Tuesday, November 15, 2011

The logic of share pricing - 1

valuationHigh price = Good price. 

How hard can it be?

Actually, share price is a deceptively simple idea, based only on the value of the company and the number of shares held by investors.

So, if the company  is valued at £1 million, its equivalent share price is £1,000K/70,000 = £14.29.

Conversely, if it has 70,000 shares outstanding at a price of £15,  it’s value is £1,500K.

For a public company, value is set by the open market.  But for a private or startup firm, it’s set internally.

Take the same company, previously priced at £15 per share, but now a year on from that.  It’s met some milestones, acquired some assets (equipment, knowledge, patents), reduced it’s overall risk.

Its ready to raise more funds by selling additional shares to private investors.

Should it set a low or high share price?

A high price is the obvious answer: it raises the worth of existing shareholders and validates the progress that the company has made.

Further, if minimizes dilution. To raise £1 million, the company must issue 40,000 shares at a price of 25, diluting existing shareholders by 36%.  However at a price of 35, only 28,571 shares must be issued, diluting by far better 29%.

But…

A low share price allows existing shareholders to buy a larger quantity of shares.  A £1 million fundraising requires a 1% shareholder to put £10,000 more in to maintain her percentage ownership.  A lower share price, 25 instead of 35, means 400 shares rather than 286 for the money, and a correspondingly bigger profit if the stock later rises in value.

So, there’s the dilemma: when the Board of Directors sets a price, do they go high or low?

It’s complicated, because Directors have a responsibility to both the company and to the investors, whose ideal price is widely different.  And when Directors are Shareholders, its a direct conflict of interest.

The tension is there in Board discussions; I hadn’t appreciated it until going through it.  But a good Board, my Board, discussed the pro’s and cons and never wavered from doing what was right for the company, not themselves.

‘just another one of those things Business School doesn’t teach you.

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