What types of actions can managers take to maximize a firm's stock price? To answer this question, we first need to ask, "What determines stock prices?" In a nutshell, it is a company's ability to generate cash flows now and in the future.
While we will address this issue in detail in Chapter 12, we can lay out three basic facts here: (1) Any financial asset, including a company's stock, is valuable only to the extent that it generates cash flows; (2) the timing of cash flows matters—cash received sooner is better, because it can be reinvested in the company to produce additional income or else be returned to investors; and (3) investors generally are averse to risk, so all else equal, they will pay more for a stock whose cash flows are relatively certain than for one whose cash flows are more risky. Because of these three facts, managers can enhance their firms' stock prices by increasing the size of the expected cash flows, by speeding up their receipt, and by reducing their risk.
The three primary determinants of cash flows are (1) unit sales, (2) after-tax operating margins, and (3) capital requirements. The first factor has two parts, the current level of sales and their expected future growth rate. Managers can increase sales, hence cash flows, by truly understanding their customers and then providing the goods and services that customers want. Some companies may luck into a situation that creates rapid sales growth, but the unfortunate reality is that market saturation and competition will, in the long term, cause their sales growth rate to decline to a level that is limited by population growth and inflation. Therefore, managers must constantly strive to create new products, services, and brand identities that cannot be easily replicated by competitors, and thus to extend the period of high growth for as long as possible.
The second determinant of cash flows is the amount of after-tax profit that the company can keep after it has paid its employees and suppliers. One possible way to increase operating profit is to charge higher prices. However, in a competitive economy such as ours, higher prices can be charged only for products that meet the needs of customers better than competitors' products.
Another way to increase operating profit is to reduce direct expenses such as labor and materials. However, and paradoxically, sometimes companies can create even higher profit by spending more on labor and materials. For example, choosing the lowest-cost supplier might result in using poor materials that lead to costly production problems. Therefore, managers should understand supply chain management, which often means developing long-term relationships with suppliers. Similarly, increased employee training adds to costs, but it often pays off through increased productivity and lower turnover. Therefore, the human resources staff can have a huge impact on operating profits.
The third factor affecting cash flows is the amount of money a company must invest in plant and equipment. In short, it takes cash to create cash. For example, as a part of their normal operations, most companies must invest in inventory, machines, buildings, and so forth. But each dollar tied up in operating assets is a dollar that the company must "rent" from investors and pay for by paying interest or dividends. Therefore, reducing asset requirements tends to increase cash flows, which increases the stock price. For example, companies that successfully implement just-in-time inventory systems generally increase their cash flows, because they have less cash tied up in inventory.
As these examples indicate, there are many ways to improve cash flows. All of them require the active participation of many departments, including marketing, engineering, and logistics. One of the financial manager's roles is to show others how their actions will affect the company's ability to generate cash flow.
Financial managers also must decide how to finance the firm: What mix of debt and equity should be used, and what specific types of debt and equity securities should be issued? Also, what percentage of current earnings should be retained and reinvested rather than paid out as dividends?
Each of these investment and financing decisions is likely to affect the level, timing, and risk of the firm's cash flows, and, therefore, the price of its stock. Naturally, managers should make investment and financing decisions that are designed to maximize the firm's stock price.
Although managerial actions affect stock prices, stocks are also influenced by such external factors as legal constraints, the general level of economic activity, tax laws, interest rates, and conditions in the stock market. See Figure 1-1. Working within the set of external constraints shown in the box at the extreme left, management makes a set of
FIGURE 1-1 Summary of Major Factors Affecting Stock Prices
1. Antitrust Laws
2. Environmental Regulations
3. Product and Workplace Safety Regulations
4. Employment Practices Rules
5. Federal Reserve Policy
6. International Rules
FIGURE 1-1 Summary of Major Factors Affecting Stock Prices
Stock Price long-run strategic policy decisions that chart a future course for the firm. These policy decisions, along with the general level of economic activity and the level of corporate income taxes, influence expected cash flows, their timing, and their perceived risk. These factors all affect the price of the stock, but so does the overall condition of the financial markets.
What is management's primary objective? How does stock price maximization benefit society? What three basic factors determine the price of a stock? What three factors determine cash flows?
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