Share Price Fuel Growth

An Explainer

Share Prices Fuel Growth

Counting cash       Pixabay       

                 

Forbes magazine will carry your photograph on its cover, if the price of your company’s share zooms high enough. There’s considerable vanity value there, but the real value of a highly priced share lies elsewhere.

Think of a share as currency. A high-priced share is a strong currency, like the US dollar - it gives the owner much more buying power than, say, the Sri Lankan rupee. This is true even if the owner never sells his shares. If this sounds a little opaque, let me explain:

When you need to borrow money to expand your business, banks will usually ask for collateral, an asset they can encash if you don’t repay interest or loan amounts on time. If you are a successful industrialist, your largest asset will probably be the shares you own in your company, and banks will peg the amount they lend you to the value of those shares. If you want a loan of 100 crores, they might ask you to hand over 250 crores worth of shares. If the shares you own in your company are worth 2500 crores, you can borrow 1000 crores. If those same shares are worth 25,000 crores, you can borrow 10,000 crores. If you are an ambitious businessman, with a huge appetite for growth, you need lots of bank finance, and  it helps - hugely - if the shares you own are priced well into the stratosphere. 

Like most of us, you prefer the strength of the dollar to the weakness of the rupee.

Business performance determines the price of a company’s shares. But only to some extent. For every crore of annual profits, a company could be valued at only 10 crores, or as much as 300 crores. A business owner looking for growth capital can get vastly more of it if his business is valued at hundreds of times its profits, rather than tens of times, as is normal. This elevated valuation is justified by a narrative of extraordinary vision, flawless execution, mythic acumen, and above all, growth. New plants, new products, new businesses, new markets. 

Growth justifies high share prices, and high share prices enable the loans that fuel that growth. 

The price of the shares needs to be supported by share markets, where buyers and sellers regularly interact to ‘discover’ the price of a share. Your view of the fair price of a share will be different from mine; but if you buy when you think it is cheap, and I sell when I think it too expensive, millions of such trades lead to an aggregated, democratic vote on the price of that share. 

Regulatory bodies such as the SEBI (Securities and Exchange Board of India) put rules in place to ensure that markets remain democratic and transparent. They seek to minimise the chances of anyone manipulating the price of a share. For example, if a share is to be traded on stock exchanges, its majority owners should not control more than 75% of its shares. The balance 25%, it is believed, gives enough voice and weight to the public to enable fair price discovery.

A business owner intent on price manipulation knows that it is tough to drive up the price of shares which are widely owned by the public. He arranges his affairs accordingly -  75% held by him, 5% with the public, 10% parked with friendly financial institutions. The balance 10% goes into black holes -   ‘shell companies’ whose only function is to hold the stock of his companies; most importantly, companies whose control cannot be traced back to him. Disguising the ownership of these companies becomes a game of cops and robbers, and if the regulatory agencies can’t - or won’t - do the hard work of ferreting out the real control of these shadowy owners, the share markets don’t function as intended, companies can get hugely over-valued, and the ambitious business owner gets his growth capital.

With only 5% of the share at play in the public markets, it is easy to support the price of shares at hugely elevated levels. On the ground, the growth of assets is real, and the media narrative continues to celebrate that growth. The valuation of the shares cannot be justified by current performance, but the tycoon is ‘building for the future’, we are continually reminded.

If all goes well, the story does play out that way. The tycoon keeps amping up the game, building his empire with a growing mountain of debt. This debt is regularly serviced, a track record that is critical to drawing even more money. For now, old debt is being paid off by new debt, but eventually - we are assured - it will be paid by enormous profits. The public shareholders, the 5%, are happy too; like the owner, they have this currency of shares, which is strengthening by the week, about which they can brag over a beer, or trade for cars, holidays, or even homes.

This massive growth machine can travel long and high, as long as it traces the flight path of steep growth. But, if it hits an air-pocket, the turbulence can be devastating, because of the debt that needs to be serviced, week after week. Growth which is leveraged by high debt is very sensitive to changes in the flight plan - a reduction in profit margins, a hike in interest rates, wars or natural calamities.

Or then, there is luck, randomness, a joker in the pack who calls foul, and attracts enough attention for investors and lenders to look under the shining hood of shared prosperity. If prolonged enquiry forces the pilot to stop climbing, the rising share prices that were the wind under his wings plummet, and create a down-draft. Banks ask for more currency to back the same quantum  of loans, and some even declare that his equity is no longer legal tender. 

Leverage, we are then reminded, works both ways. 

To quote Warren Buffett:

“When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people."