Effects Of Small Changes In Stock Prices On Corporate Values
May 1, 2002
The ability of a company to generate cash flow has an important effect on the value of a company's stock. But the opposite is also true: stock prices can affect a company's cash flow. Small changes in stock value can have a large and permanent impact on revenues, investment and cash flows, which, in turn, affect stock prices.
When stock prices decline, some of the company's stakeholders (suppliers, employees, costumers, lenders) will decide to do less business with the company.
- The relationship of a company with its stakeholders can be symbiotic --especially if companies produce complementary products, like Microsoft and Intel, and if there are "network externalities" such that the more people consume a product, the higher its value.
- In the presence of symbiotic relationships, even a small drop in stock prices can trigger a cascade of negative feedback effects, while the opposite is true for small rises in stock prices.
- By changing the amount and type of information they release, managers can influence the feedback effects that comes from stock price fragility.
- Mature companies can lower the chances of a negative cascade by reducing transparency; smaller, younger firms have everything to gain by attracting new stakeholders and would therefore benefit from more transparency.
Stock price-cash flow feedback effects can also explain why managers tend to invest in short-term projects (they might want to increase the chance of a positive cascade) and why an increasing number of companies decide to go public at an early stage and offer shares at large discounts (they try to attract new stakeholders and trigger a positive cascade).
Source: "Cascades in Symbiotic Relationships," Economic Intuition, Summer 2001; based on Avanidhar Subrahmanyam and Shendam Titman, "Feedback from Stock Prices to Cash Flows," the Journal of Finance, December 2001.
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