Reducing Your Cost of Capital Gives You a Discount on Everything You Buy

How would you like it if you could get an additional discount off of almost everything you buy, after having negotiated your best deal? That's what reducing your cost of capital (especially your cost of equity) can do for you.

Most CEOs are delighted if their company's stocks can sell around the industry average price/earnings ratio. If they can do better than that, the leaders are even happier and will usually avoid using the stock to buy anything in order to protect the multiple. Both views are major missed opportunities. Consequently, almost all companies today lack the fundamental skill to create and sustain a stock-price premium that can be used to lower the company's cost of providing offerings.

With a sustained price/earnings premium, a company can use its stock in ways that shareholders approve to have the equivalent of a discount compared to competitors on everything the company purchases, from other companies to compensation to supplies. For example, one company may be looking to purchase another for cash. Let's assume that the price is one hundred million dollars. If the company that is purchased earns more cash than the interest charges on the money borrowed to buy it, the acquiring company sees its cash-flow-per-share rise.

If not, the acquisition is reduces cash-flow-per-share. If another company has a high stock-price multiple that will be unaffected by making the same acquisition, that stock-based purchaser sees its cash-flow-per-share break-even coming at a much higher price for the company.

Companies with rapid growth in stock price also find that the cash costs of their compensation for key employees falls. Employees are interested in having stock options rather than cash both because of the upside potential and because tax rates are lower on this income. Further, the stock options don't affect company earnings as much as cash payments do.

Also, companies can issue stock to get the cash to make other kinds of investments and purchases. Where the source of this cash is cheap enough, it is like getting a discount on whatever the money is used for.

Here's an example that many people never consider for implementing such a strategy: Issue new stock whenever your multiple is well above its historical trend and buy back share (in excess of what's required to offset employee stock options) whenever your multiple is well below its historical trend level.

Copyright 2008 Donald W. Mitchell, All Rights Reserved