A Return to Reality

A Return to Reality
By Arthur Cooper
(c) Copyright 2004

There are real lessons for managers and employees to learn from the behaviour of the stock market over the last few years.

Someone running their own one-man business knows what is important to him as far as his business is concerned. He needs money to live on and he needs money to pay his bills on time. He needs income and cash flow. Until he comes to sell his business it really doesn’t matter to him what its capital value is. What he needs and wants in the immediate is a flow of profits from his business. That is what matters to him.

If he wishes to sell up and retire, or if he wishes to raise money to reinvest in his business, then that is the moment when it is important to know the ‘value’ of his business. And it is not what he thinks it is worth, but what the buyer or the bank thinks it is worth.

And how will they decide this? They will look at his books and value the business based on two fundamental elements – the stock of course, and above all the income.

So we come back again to income and the profit that results from that income. There is no other way to truly value a business. This applies to businesses of any size, even the largest of publicly quoted companies. And yet that is not what we have seen in recent years.

In the recent past we have seen stock market prices of publicly listed companies rise and rise to unbelievable heights even when in some cases there are no profits either now or in the foreseeable future.

The public of course has a herd instinct, and in times of large price movements does not want to be left behind, so will buy because everyone else is. In consequence the price goes up beyond a sensible level.

The trouble is that if you have bought shares in a non profit making company you won’t be getting dividends and the only way you will ever realise a gain is by selling the shares. You can hold them as long as you like but as long as there is no profit and no dividend you will be out of pocket.

Knowing this, when think that they have reached their peak you will decide to sell. Unfortunately the chances are that others will too. The mass selling begins. When prices come down the same thing happens as when they went up, only in reverse. They fall beyond the point where they should reasonably be.

And then – eventually – prices settle back to more considered levels. We have seen the beginnings of this recently. Some prices have fallen disastrously. In some cases bad management or fraud has been revealed. Some have fallen in line with the market in general. Others have survived with very little damage to their stock market price. A few actually rose.

For the future – who knows? But it is clear that much of the movement on the way up was not based on fundamental analysis of the businesses concerned but on the public going with the flow. As companies are examined more closely in the light of the failure of others we can expect prices to move in the longer term back to more sensible levels.

But for the company itself, does all this matter? What of the company as an entity in itself, as opposed to the individuals within it? Does the stock market price matter?

To directors and employees on bonuses related to the price of course it matters. To individual shareholders of course it matters. To potential shareholders (by way of IPOs or bonuses) of course it matters. But to the business itself?

Does a higher stock market price increase the profits?
No, it does not.

Does a higher price provide higher salaries for the employees. No, it does not.

If the company is sold it is the shareholders who profit, not the company as such.

But of course we know the answer. The stock price does matter to the company. It matters in the same way as the bank’s valuation of an individual’s small business matters to him. A higher price makes it easier or cheaper for the company to borrow money. And the only reason for the company to borrow money is to enable it to reinvest to enable it to further increase its profits. If it does not increase profits by borrowing then it should not be borrowing. We are back once again to profits.

So where is this all leading? Why is all this of interest to managers and employees? What lessons are there for the self employed and those working in small private businesses – shops, workshops, restaurants, etc.?

The lessons are clear.

What matters is profit. Income minus expenditure. And to pay bills cash flow, too, is vital. Get this right and you stay in business. Get it wrong and ultimately you will fail. This is always true over the long term. But unfortunately this has been lost sight of by many in the recent scrambling over stock market prices.

So let’s get back to fundamentals. Let us plan for the longer term. Let us invest in the future. Let us train our managers and future captains of industry in the things that really matter to business. As individuals let us never stop trying to improve. Maybe then we can all look forward again to a prosperous and stable future.