With stock prices falling sharply in recent months, here’s how businesses may be impacted.
Higher dilution
It is common practice for tech companies to offer employees stock-based compensation (SBC). This can come in the form of stock options or restricted stock units that vest over time.
SBC is useful for companies in a few ways. First, it incentivises employees to stay for the long-term to reap the rewards of stocks that vest over time. Second, it allows employees to participate in the growth of the company’s stock price. Third, it aligns employees’ interests with shareholders as the employees become shareholders themselves. Fourth, it helps companies to save cash as it is a non-cash expense.
The down-side though is that SBC results in a higher number of outstanding shares in a company, which dilutes existing shareholders. The amount of dilution is usually dependent on the stock price at the time. Take for example a company that offers an employee a pay package that includes $100,000 in shares. If the share price is at $100 a share, the employee gets 1,000 shares. But if the stock price is at $50 a share, the employee will get 2,000 shares. When stock prices are lower, the higher number of shares issued results in higher dilution for the company’s other existing shareholders.
With this in mind, it is important for investors in a company that uses SBC to keep an eye on the growth in the outstanding share count in the future.
More expensive capital
Numerous companies took advantage of soaring stock prices in the last two years to raise cash. For instance, SEA Ltd (NYSE: SE), raised US$3.5 billion through a secondary offering last year by issuing 11 million new shares at a stock price of US$318 in late-2021.
Today, SEA Ltd’s stock price has fallen to around US$70 per share. In order to raise the same US$3.5 billion today, SEA will need to issue around 50 million shares. This is nearly five times as many shares that were issued in late-2021 and would mean significantly more dilution for SEA’s existing shareholders.
With capital getting more expensive, in both the bond and the equity markets, companies will need to be more prudent with their cash. Cash burning companies will need to find ways to reduces losses or turn cash flow positive in order not to have to raise cash at expensive rates.
Buybacks may be attractive
Conversely, companies that have lots of cash or have a very cash-generative business can take this opportunity to reduce its outstanding share count. Buying back stock when the price is down can be effective in increasing shareholder value. Warren Buffett’s Berkshire Hathaway (NYSE: BRK.B) is a classic example of a company that has taken advantage of a relatively low stock price to accelerate its share buybacks.
But even software companies are joining the party. For example, Zoom Video (NASDAQ: ZM) is looking to take advantage of its cratering stock price by buying back shares. In its latest earnings announcement released on 28 February 2022, Zoom said that its board of directors had authorised a stock repurchase program of up to US$1 billion. With a price-to-free-cash-flow ratio of less than 20, this seems like a great opportunity for Zoom to reduce its share count for shareholders.
The bottom-line
Falling stock prices can have both a negative or positive impact on companies. Companies that have cash on hand for buybacks can benefit from this bear market. On the other hand, companies that are short of cash may end up having to raise money at unfavourable terms.
We often hear the phrase “cash is king.” It is in times like this that these words ring truer than ever.
Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
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Disclosure: Jeremy Chia owns shares in Sea Limited and Zoom Video.
