Watch Out for Falling Stock Prices

Why does a company care if its stock loses value?

How does the stock-price plunge affect corporations?

Stocks have lost $8.1 trillion worldwide since July 24, representing 14.8 percent of global market capitalization. Investors are clearly taking a major hit, since they own the stocks. But does a drop in share price matter to the individual corporations in question?

It matters indirectly. If you buy a share of Apple for $300 and sell it for $250, the company itself doesn’t lose any money. In that sense, day-to-day fluctuations in stock prices don’t mean much to stable corporations with stockpiles of cash. (Apple, for instance, currently has $76 billion stored away.) A drop in market value can, however, destroy a company that relies on outside financing (PDF) to fund its operations. The difficulty of obtaining cash through a stock offering when share prices are down is obvious—the same number of shares sold at a lower price will raise less money. Depressed stock prices also increase the cost of borrowing, because banks take a company’s share price into account when deciding whether to extend credit and at what interest rate. Many businesses, especially young businesses in industries with high research and development costs like biotech, can’t survive without access to cheap capital.

Falling stock prices might also undermine employee retention. Many companies use stock options as an enticement to stay with the company, because an employee has to stick around a while to exercise them. If an executive doesn’t believe her options are going to be worth anything—a stock option is useless if the market price is lower than the option price—she’s more likely to jump ship. Customers might also be hesitant to deal with a corporation whose stock price is dropping through the floor, because they question whether the company will be around to fulfill a contract or stand behind a product warranty.

On a personal level, company executives worry about stock price, because disgruntled shareholders regularly fire the CEO and her team when a company underperforms.

To see how falling share prices can kill a company, consider the plight of Lehman Bros. as detailed in Andrew Ross Sorkin’s book Too Big To Fail. Lehman executives argued vehemently that they had enough capital and other assets to weather the 2008 economic downturn, and many analysts agreed until the company’s very last days. The problem, according to CEO Dick Fuld, was that short sellers—people who bet that the stock price would decline—drove the stock down so far that lenders wouldn’t deal with the company and clients withdrew their capital. In just a few days, Lehman went from one of the biggest banks in the world to a company that couldn’t pay its bills. Analysts are still arguing over whether short sellers destroyed a perfectly good company or did the economy a favor by hastening the inevitable demise of a teetering behemoth that would only have dug a deeper hole if given more time.

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Explainer thanks Edward I. Altman of NYU Stern School of Business and Malcolm Baker of Harvard Business School.