One of the fundamental theories in finance is called Pecking Order Theory.
The theory outlines that companies have three main financing options and that there is a specific order as to which is the most beneficial to the company.
Using the company’s own cash is seen as the best financing option, going into debt is seen as the second best option and selling equity (ownership) in the company is seen as the worst option.
From this you can see that listing on a stock market and selling stock is technically the worst thing that a company can do. This is because a company loses ownership over itself and has to compensate third parties on a ongoing basis, with money that could have otherwise remained inside of the company.
Of course, it is possible for a company to buy back their own stock but this usually happens at much higher prices.
For example, Apple originally sold their stock for $0.10 (adjusted for stock splits) during their IPO in 1980, which is considerably less than the $110.44 that they have to spend to buy their stock back today. You can see how expensive selling equity can be for a company as a financing option.
Seeing as selling equity and listing on the stock market is a terrible idea for a company, the important question to ask is: Why on earth do they list on the stock market?
Well the answer is easy. According to Agency Theory, the primary aim of a company is to maximise shareholder wealth and it is common for companies to sell equity early on in their development to venture capitalists or angel investors.
They do this in the early years because it can be difficult to raise money with debt at that time and cash is often limited. Companies therefore go to outside investors to raise money, with the knowledge that they don’t necessarily have to pay anything to that investor in the short term.
As the years pass by, listing on a stock market is the best way to maximise shareholder wealth, allowing early shareholders to easily sell their stakes in the company at the highest price possible.
If companies excite stock market investors enough, the stock price will shoot up to very high levels. This allows early stage shareholders to sell their positions at incredibly high valuations, providing them with a large return on investment.
When a company lists on a stock market for the first time, it can be a risk for new investors. This is the case because new investors can become drawn into the hype of an initial public offering, when in reality it’s utility is to serve as a wealth maximising tool for early stage investors.
It can often be the case that the stock price of a new stock decreases significantly after it completes an IPO. This happens because the hype dies down and stock market investors realise that the company isn’t as valuable as they were made to believe.
New investors can sometimes suffer at the hands of the motivation to maximise wealth for early stage investors as a result. The best thing to do is to avoid IPOs and to tune out of the hype – which usually comes via the media.
A key example of a recent IPO would be Uber. The company sold their stock for around $41 during the IPO after the hype for their stock was intensified by the media.
The hype train continued for around 1 month as the stock hit a high of $46, but then the wheels started to fall off. Investors started to realise that Uber isn’t a great investment at the price in which they were paying. Demand started to fall as a consequence.
In the 6 months after Uber’s IPO, the stock price fell drastically to $27 – which is a decrease of approximately 35%.
Since the IPO in May 2020, Uber stock has so far never been priced at $41 or above again.
It’s not always the case that a company does an IPO to maximise wealth for early stage investors, sometimes it can be the case that they genuinely want to raise capital for a new project. It’s just important to bear in mind that in most cases, companies do not necessarily have your best interests in mind during an IPO.
It is the motivation of a company to buy back equity in their own company over time in order to retain as much ownership within the company as possible.
This is exactly why companies like Apple have been buying their own stock since 2013.
The ideal scenario for a company is to raise venture capital, list on the stock market and to eventually delist from the stock market.
The problem for most companies, however, is that their market capitalisation is so high (and often continues to go up and up) that they may never be able to delist from the stock market.
In the case of Apple, for example, their market capitalisation is almost $2trillion, which they couldn’t possibly get to financially.
As for whether it is bad for outside investors for a company to buy back their own stock, it depends on the perspective of the investor.
When a company buys back their own stock, they are reducing the number of stocks that are freely available. This has the effect of increasing the stock price, particularly if the demand for the stock remains high. The more a company buys back, the higher the stock price could go.
This isn’t such a good thing for short term investors, but it’s a great thing for long term investors. The reason for this is that the stock price will be more stable, particularly if it goes down. This is because the company will buy more stock back if the prices goes down as it is cheaper – which has the effect of stabilising the stock price. This makes it less attractive for short term investors as there are less opportunities to ‘buy low and sell high’.
When it comes to investing, the worst thing that can possibly happen is when a stock that you own goes to zero.
The good news is that it doesn’t happen very often but it’s important to always have in mind that it could happen.
When a stock goes to zero, there are two main outcomes – that the company is acquired or that the company goes into administration.
Sometimes the most positive outcome is when a company is acquired because investors in the company can often become shareholders in the acquiring company. The issue though is that the acquiring company may offer shares at a price that are well below the original amount that someone invested.
This happened recently in the UK when a company called Sirius Minerals was acquired for just 5p a share. Many investors lost huge amounts of money after buying the stock with their life savings at 40p a share.
It’s easy to feel sorry for those investors (and I do feel for them) but Sirius Minerals was a speculative start-up company that didn’t make a profit, so it certainly wasn’t the best investment to put your life savings into.
When it comes to the company going into administration and eventually liquidating their assets, this can actually benefit some investors. If an investors bought stock at a market capitalisation that was well below the net asset value of the company, it is possible for them to make a large profit.
The process starts by paying off the company’s debts first, with remaining money being given to shareholders.
For example, if the assets of a company are worth $100m and the company has $20 in debt, $80m would remain after the debtors had been paid off. If an investor bought stock at a market capitalisation of $40m, they could make a 100% profit.
The assumption here is that the assets of the company are sold off at a fair price, which is often not the case.
To avoid this situation all together, make sure you invest in companies that have strong balance sheets. An easy way to do this is to use a ratio called the current ratio, which is used to measure a company’s ability to meet their short term liabilities.
The current ratio is calculated by divided the current assets of the company by the current liabilities.
A current ratio that is below 1 means that the company has greater liabilities than assets, which means that they may struggle to cover their costs in the short term.
Current ratios vary from one industry to another but ratios between 1.5 and 2 are generally seen as healthy.