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10.5 The Bigger Picture

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Describe how stock fits into the larger picture of finance.
  2. Explain ethical considerations regarding stock.

Like bonds, selling stock allows the issuer to raise capital for new or ongoing projects. Unlike bonds, selling shares of common stock is effectively selling a “piece” of the company. Equity financing tends to command a higher risk premium, so the expected returns by investors is higher. If a company is considered risky, particularly in its early stages, equity financing might be the only reasonable way to raise the necessary funds, even if it entails possibly losing voting control over the board.

Through the election of board members, shareholders can exercise their power to approve or disapprove of the company’s actions. This exercise of corporate governance, combined with the effect of the cost of financing, causes managers to have multiple reasons to consider the desires of shareholders when taking action.

Investors must understand what drives stock prices if they are to properly assess the risk and return of adding stocks to their portfolios.

Ethical Considerations

Since the board of directors is elected by the shareholders, owners of stock must feel some responsibility for the companies in which they have invested. Activist shareholders have become more commonplace, introducting ballot measures and contesting board elections to push corporations for or against various agendas. Of course, a dissatisfied shareholder can always choose to sell the stock and invest elsewhere, but through their ballot they have an extra means of influence over the direction of the company. Some companies make provisions to discourage too much shareholder intervention, for example, by making it more difficult to replace the entire board at once. Since many senior managers are board members at other companies, there can be a level of “cronyism” between companies as board members support their management friends.

Another area of concern is that many managers believe that stock prices are particularly sensitive to short-term news like quarterly earnings, and this can influence them to try to manipulate the numbers to their perceived advantage, either legally or, in some cases, fraudulently. In an extreme case, managers can buy or sell stock based upon their knowledge of information not yet revealed to the public (or they can “tip off” their friends or relatives). While in many cases these actions can be illegal, there are many countries and circumstances where regulation is absent or under-enforced.

Key Takeaway

  • Shareholders are both a source of capital and enactors of corporate governance. Through both of these can they influence management’s behavior.

Exercises

  1. Some managers attempt to “smooth out” earnings over time, to minimize the volatility of the stock price. Is this damaging or beneficial to the stockholders?
  2. Sarah owns many shares of stock in ABC Corp. Recently, ABC has been cited for excessive pollution. What actions could Sarah take if she wishes to influence the future actions of ABC’s management?
  3. Bill is a manager at XYZ, and he recommends to the board that they nominate Chris for the open board seat because he is highly experienced in the field. Chris is currently a manager at FGH Inc., where Bill is a member of the board. Are there any potentially issues with Bill’s recommendation?