Classroom | Corporate action - how do bonus, stock split, buyback and dividends work? (Equity: Part 12)

Part 12 of the Classroom delves into various kinds of corporate actions and how investors should handle them.

• What is a rights issue, and why do companies come out with rights issues? Rights issue is the process of a company raising funds from its existing shareholders, by offering equity shares in proportion to their existing holding.

For example, a 1:2 rights offer means the shareholder will get a chance to buy 1 share of the company for every two he is holding.

A rights issues gives the shareholders the right to buy the shares on offer, but  they can choose not to subscribe to it.

Companies go in for rights issue when they need funds, but do not want to take on more debt.

Rights shares are usually offered at a discount to the market price. It has to be priced that way else there would be no incentive for shareholders to subscribe to the issue. They could as well buy the shares from the open market.

• What happens to my rights shares if I choose not to subscribe to them? Can I sell my rights to somebody else who may want to buy the shares?

You can choose not to subscribe to the rights shares you are entitled to. In that case it is up to the company as to what it wants to do with the unsubscribed rights shares. You can also apply to the company for additional rights shares.

Yes, you can renounce the rights shares, either the entire lot or part of it, in favour of somebody who wants to buy the shares.

• What is a bonus share issue, and why do companies offer bonus shares?

Bonus shares are free shares given to shareholders of the company.

Bonus shares do not involve cash outflow from the company and are issued out of the company’s reserves. The net worth of the company does not change post-issue of bonus shares as the amount that leaves the reserves ends up under equity capital.

Some investors hold on to these bonus shares in order to take advantage of compounding, while others consider bonus shares as dividend and encash it immediately on receipt.

Bonus can be allotted in any ratio of the existing shareholding as decided by the board. Post the record date, the share price of the company is adjusted for the increased capital.

Thus, if a company is trading at Rs 200 just before the record date for a 1:1 bonus, the share price post the record date will be Rs 100. That is because the equity capital of the company may have doubled but as the value (read market capitalisation) of the company will not change, the price gets adjusted to reflect the same.

So if an investor is holding 1,000 shares priced at Rs 200 ahead of the record date, post the issue of bonus shares his account will show 2,000 shares but the price of shares would be Rs 100 and the value of the holding will be Rs 200,000 as was the case earlier.

• When a company announces a bonus share issue, the stock price usually rises. Does a bonus issue make a stock more attractive?

A bonus issue makes no difference to operating performance of the company. But often, it improves market sentiment for the stock. Some investors see the bonus issue as a message of confidence from the company. By offering bonus shares, the company is indirectly saying that it is confident of handling the expanded equity base. If a stock is illiquid, a bonus issue increases the number of shares in circulation, and that helps in attracting newer investors.

• What is a stock split, and why do companies do that?

Stock split, as the name suggests is a split in the face value of the share. It is done to increase the number of shares in circulation, and also make the stocks appear cheaper to retail investors. Most retail investors are reluctant to buy high priced stocks. High priced here means high in absolute terms, and not in the context of their earnings.

Say a stock with a face value of Rs 10 is quoting at Rs 5000. If the company splits the face value to Rs 1, the price will also be reduced to one-tenth, Rs 500.

Strangely, many retail investors don’t mind buying ten shares at Rs 500 each even if they were hesitant to buy one share when that stock was quoting was Rs 5000.

• Does a stock split affect the fundamentals of a company in any way?

No, it does not. The only purpose of stock split is to increase the liquidity in the stock.

• What is a share buyback, and why do companies buyback their shares?

Buyback of shares is the process by which companies repurchase equity shares from shareholders, usually at a premium to market price.

There are many reasons why companies buyback shares. It is one way of returning cash to shareholders if the company does not see merit in reinvesting the money to expand the business. Sometimes when the stock price is falling sharply, companies announce a buyback to signal a floor price for the stock.

Shares bought back from the market are extinguished or deducted from the share capital. A buyback thus helps in reducing the equity capital of the company. This, in turn, helps in improving the earnings per share and dividend per share of the company. Higher earnings per share result in higher share price even if the price to earnings multiple of the company remains the same.

These days buyback is considered as a better way of rewarding the shareholders than paying dividend.

How do I decide whether or not to participate in a buyback offer?

The decision to participate in a buyback offer of a company depends on the time you want to stay invested in the company.

This is because a company announcing a buyback issue is normally perceived to be one whose fundamentals are strong. The main reason they are announcing a buyback is that they have more money than they would need in the current situation. Many smart investors look for companies announcing buybacks to invest in them.

If your interest in the company is only for a short term period then consider these factors before participating in a buyback issue.

First is the premium to the current price at which the buyback is announced. If the premium is good, more investors would be interested in applying for the shares while if the premium is moderate fewer investors would participate in it.

Second is the number of shares the company intends to buy in the issue. Higher the size of the issue higher is the chance of your offer being accepted by the company.

A third factor to note is the non-promoter holding or the free float of the company. A buyback issue is open for non-promoters of the company. Higher the free float more will be the number of investors who will be willing to submit their shares. 

• How can I know the probability of my shares being accepted in the buyback offer?

Suppose a company has offered to buyback 5 percent of its capital. If the promoter holding is say, 60 percent this means that theoretically 40 percent of shares can be offered.

Now if the company has an equity capital of Rs 10 crore consisting of 1 crore shares, the buyback offer of 5 lakh shares (5 percent) can theoretically see applications from 40 lakh shareholders.

So the chance of your shares getting picked up is one in eight (5 lakh/40 lakh) or 0.125. In other words for every 100 shares that you will submit 12 or 13 shares can get accepted. This, of course, is the worst-case scenario as not all the 40 lakh shareholders would be submitting in the issue.

If you are a short term trader who has bought the shares only to participate in the buyback the question to ask would be what will you do with the remaining 87/88 shares that will not be accepted. If the share price stays at the same level or is higher than what it was before the buyback then there is a chance of making a profit out of the entire transaction.

But if the share price falls post the buyback then the gains of acceptance of the 12/13 shares in the buyback will be offset by the loss in selling the residual shares.

• Why do some companies not pay dividends even if they are making decent profits?

A dividend is normally paid by the companies out of excess profit that was generated during the year. If a company is planning an expansion or feels that going ahead the external environment may be tough, it can defer its dividends.

However, if the company continues to avoid paying a dividend and keeps on stacking cash without any signs of investing for the future, investors should be wary

• Is consistent dividend paying track record a good reason to invest in a stock?

A consistent dividend-paying record is a good reason but it should not be the only reason to invest in a company. There may be companies which pay a good dividend but the core business could be slowing, and earnings growth weak. In such a situation, the market will assign a lower price earning multiple to the stock, causing the stock price to languish. A good dividend yield, but little or no appreciation in the stock price is not a good combination. Also, one needs to see if the company is stressing itself in paying a dividend from its cash flows.

Nonetheless, a consistent dividend-paying and growing company should be on the radar of investors and every fall in the share price should be considered as an opportunity to invest.