STOCK PRICES AND SHAREHOLDER VALUE
At the outset, it is important to understand the chief goals of a business. As we will see, the goals of a sole proprietor may be different than the goals of a corporation. Consider first Larry Jackson, a sole proprietor who operates a sporting goods store on Main Street. Jackson is in business to make money, but he also likes to take time off to play golf on Fridays. Jackson also has a few employees who are no longer very productive, but he keeps them on the payroll out of friendship and loyalty. Jackson is clearly running the business in a way that is consistent with his own personal goals—which is perfectly reasonable given that he is a sole proprietor. Jackson knows that he would make more money if he didn’t play golf or if he replaced some of his employees, but he is comfortable with the choices he has made, and since it is his business, he is free to make those choices.
By contrast, Linda Smith is CEO of a large corporation. Smith manages the company on a day-to-day basis, but she isn’t the sole owner of the company. The company is owned primarily by shareholders who purchased its stock because they were looking for a financial return that would help them retire, send their kids to college, or pay for a long-anticipated trip. The shareholders elected a board of directors, who then selected Smith to run the company. Smith and the firm’s other managers are working on behalf of the shareholders, and they were hired to pursue policies that enhance shareholder value. Throughout this book we focus primarily on publicly owned companies, hence we operate on the assumption that management’s primary goal is stockholder wealth maximization, which translates into maximizing the price of the firm’s common stock.
If managers are to maximize shareholder wealth, they must know how that wealth is determined. Essentially, a company’s shareholder wealth is simply the number of shares outstanding times the market price per share. If you own 100 shares of GE’s stock and the price is $35 per share, then your wealth in GE is $3,500. The wealth of all its stockholders can be summed, and that is the value of GE, the item that management is supposed to maximize. The number of shares outstanding is for all intents and purposes a given, so what really determines shareholder wealth is the price of the stock. Therefore, a central issue is this: What determines the stock’s price?
Throughout this book, we will see that the value of any asset is simply the present value of the cash flows it provides to its owners over time. We discuss stock valuation in depth in Chapter 9, where we will see that a stock’s price at any given time depends on the cash flows an “average” investor expects to receive in the future if he or she bought the stock. To illustrate, suppose investors are aware that GE earned $1.58 per share in 2004 and paid out 51 per- cent of that amount, or $0.80 per share, in dividends. Suppose further that most investors expect earnings, dividends, and the stock price to all increase by about 6 percent per year. Management might run the company so that these expectations are met. However, management might make some wonderful decisions that cause profits to rise at a 12 percent rate, causing the dividends and stock price to increase at that same rate. Of course, management might make some big mistakes, profits might suffer, and the stock price might decline sharply rather than grow. Thus, investors are exposed to more risk if they buy GE stock than if they buy a new U.S. Treasury bond, which offers a guaranteed interest payment every six months plus repayment of the purchase price when the bond matures.
We see, then, that if GE’s management makes good decisions, the stock price should increase, while if it makes enough bad decisions, the stock price will decrease. Management’s goal is to make the set of decisions that leads to the maximum stock price, as that will maximize its shareholders’ wealth. Note, though, that factors beyond management’s control also affect stock prices. Thus, after the 9/11 terrorist attacks on the World Trade Center and Pentagon, the prices of virtually all stocks fell, no matter how effective their management was.
Firms have a number of different departments, including marketing, accounting, production, human resources, and finance. The finance department’s principal task is to evaluate proposed decisions and judge how they will affect the stock price and therefore shareholder wealth. For example, suppose the production manager wants to replace some old equipment with new, automated machinery that will enable the firm to reduce labor costs. The finance staff will evaluate that proposal and determine if the savings are worth the cost. Similarly, if marketing wants to sign a contract with Tiger Woods that will cost $10 million per year for five years, the financial staff will evaluate the proposal, looking at the probable increased sales and other related factors, and reach a conclusion as to whether signing Tiger will lead to a higher stock price. Most significant decisions will be evaluated similarly.
Note too that stock prices change over time as conditions change and as investors obtain new information about companies’ prospects. For example, Apple Computer’s stock ranged from a low of $21.18 to $69.57 per share during 2004, rising and falling as good and bad news was released. GE, which is older, more diversified, and consequently more stable, had a narrower price range, from $28.88 to $37.75. Investors can predict future results for GE more accurately than for Apple, hence GE is less risky. Note too that the investment decisions firms make determine their future profits and investors’ cash flows. Some corporate projects are relatively straightforward and easy to evaluate, hence not very risky. For example, if Walmart were considering opening a new store, the expected revenues, costs, and profits for this project would be easier to estimate than an Apple Computer project for a new voice-activated computer. The success or lack of success of projects such as these will determine the future stock prices of Walt-Mart, Apple, and other companies.
Managers must estimate the probable effects of projects on profitability and thus on the stock price. Stockholders must forecast how successful companies will be, and current stock prices reflect investors’ judgments as to that future success.
What is management’s primary goal?
What do investors expect to receive when they buy a share of stock?
Do investors know for sure what they will receive? Explain.
Based just on the name, which company would you regard as being riskier, General Foods or South Seas Oil Exploration Company? Explain.
When a company like Boeing decides to invest $5 billion in a new jet airliner, are its managers positive about the project’s effect on Boeing’s future profits and stock price? Explain.
Would Boeing’s managers or its stockholders be better able to judge the effect of a new airliner on profits and the stock price? Explain.
Would all Boeing stockholders expect the same outcome from an airliner project, and how would these expectations affect the stock price? Explain.
