Jorge Luis Borges was a great writer whose writings were succinct and full of deep insights, woven around a wry sense of humor on some occasions. His ‘book’ titled Labyrinths is actually a collection of short essays – a must read. He could never understand why people wrote massive tomes. Inspired by his views, I look at topics which can be expressed short.
There are many companies for who the stock market is reduced to a wealth calculator and no longer of access to additional capital. Let me explain.
Any standard textbook on Corporate Finance will tell you that the goal is shareholder wealth maximization. And that is a function of stock prices, the standard metric in modern times to estimate wealth – of individuals and organizations. Investors pay attention to ‘earnings per share’, which is easy to understand because it tells you what one share earns. We arrive at this figure by dividing the profits that shareholder can lay claim to by the number of shares. What investors are really interested in is the rate at which the EPS grows. If your wealth is in gold or silver, the key variable affecting your wealth is the price of gold and silver. This is a no brainer.
So, the question is how to ensure that the EPS continues to grow at successively higher rates. Common sense suggests that the profits available to shareholders keeps growing at a higher rate. Why is this important? Because it lets companies raise fresh capital at higher prices than otherwise.
It is important here to reinforce the two fundamental dimensions (or functions) of the stock market – a mobiliser of savings and a source of revenue, revenue being either dividends or capital gains. The first function ceases to have meaning for many companies who do not need fresh capital at all, but not the second. Their businesses are so productive of positive cash flows that they just don’t need to access the stock market to raise additional capital. And there are others which struggle to continue to generate higher revenues facing the threat of declining EPS. That just is unacceptable as wealth diminishes.
Ironic then that both types of companies resort to one action – returning capital to shareholders. And by the laws of simple arithmetic, the EPS grows because it has actually grown but made to appear to grow – there now are less number of shares over which the profits have to be divided. There are global companies who made a commitment to shareholders of a specified EPS by a certain time frame. If you can’t reach it by growing more revenues, return capital. This is the buyback you read about in the business media.
Now you know why there are businesses for who the stock market is just a wealth calculator. Nothing more.
