In a world where everything is dominated by business and finance, corporate actions control a company’s future whether it is good or bad. Also, corporate actions heavily impact a company and its share price. A good understanding of the corporate life cycle can give you a clear idea of a company’s ethical health and financial health which in turn helps you to determine whether to buy a particular stock or not.
In this blog, we explore more about corporate action processing and how it affects stock prices.
What are Corporate Actions
A corporate action is an initiative taken by the board of companies of a public limited company that brings an actual change to the financial securities – equity or debt issued by the company.
From pressing financial matters such as bankruptcy or liquidation to a firm changing its name, corporate actions can range from a number of things. Some of the common examples of corporate actions are dividends, mergers, acquisitions, and stock splits.
Corporate Actions can be acted in Two Ways:
Mandatory and Voluntary
Mandatory corporate action is automatically applied where investments are involved. Voluntary action, on the other hand require investors’ actions to be applied.
Acquisitions, company name changes, and stock splits are some of the most common examples of mandatory corporate actions. Optional dividends, tender offers, and rights issues are examples of voluntary action.
Common Corporate Actions
As we discussed above, common corporate actions include stock splits, merger and acquisition, cash dividends, rights issues, and spin-offs.
A cash dividend is a common corporate action that has the ability to change a company’s stock price. A cash dividend is defined as a distribution of the company’s earnings to a specified class of shareholders. Before releasing a dividend to its shareholders, approval has to be taken by the company’s board of directors.
A stock split is a common example of corporate action that changes a company’s existing shares. In a stock split, the number of outstanding shares is increased by a specific multiple.
A reverse split could be implemented by a company that wants to force up the price of its shares. The reverse split is a sign that the company’s stock has gone down, such that its executive wants to high the price or at least make it appear that the stock is stronger.
Merger and Acquisition (M&A) are the third type of corporate action that brings about material changes to companies. In a merger, two or more companies combined to form a new company. The existing shareholders of merging companies maintain a shared interest in the new company.
Spin off is another type of corporate actions where an existing public company sells a part of its assets or distributes new shares so that it can create a new independent company. A spin-off could indicate a company ready to take on new challenges.
Here, we elucidate some of the prominent corporate actions and their impact on stock prices:
Major Corporate Actions and their impact on Stock Prices
1. Bonus Shares
Bonus shares are additional or extra shares issued by a company to its shareholders. For example, the 1:1 bonus issue implies that shareholders get additional shares for every share they hold. The company releases bonus shares only when a company faces liquidity issues or not in a position to distribute dividends. The company issues bonus shares from its cash reserves or profits.
It is always said that the things that appear to be free will always have some implicit costs. Whenever a company buys its bonus shares, the share price of that price falls down in the same proportion as the bonus share issue. Along with the share price, the EPS of a stock will also go down.
However, over the long term, as the stock price increases, investors tend to gain profit again. There is no tax on the allotment of shares. Bonus shares depict a clear indicator that shows a company’s good health and its earnings, which would rise over 2-3 years.
Another point should be noted that the interest in bonus shares has increased after the company announced it. Therefore, it is suggested to check the company’s recent earnings growth trajectory, capital expenditure, visibility and schedule of commissioning of Capex plans.
Dividends are regular incomes that a shareholder receives from a company out of its profits and reserves. Also, when a company does not find any suitable way to deploy its funds, it declares a dividend to share its profit/reserve with its shareholders.
The dividend is usually quoted as a percentage of the face value of the share. For example, XYZ limited company had declared an interim dividend of Rs 10 per share, whose face value was Rs 10, then the exact dividend is 100%.
If we talk about the tax implications on dividend income, then investors need not pay any tax up to Rs 1,00,00,00. i.e. Income from dividends is tax-free in the hands of investors up to Rs 10,00,00 and beyond then the tax is levied @10 percent beyond Rs 10,00,00.
3. Rights Issue
A rights issue is when fresh shares are issued by the company to its existing shareholders instead of the public at large. Unlike bonus shares, the Rights issue comes with a price – usually at a discounted price. For example, a 1:5 Rights issue means you can subscribe to 1 additional share for every five shares you hold.
It should be noted that a company may issue Rights issues to finance its expansion or for debt reduction. Therefore, it is suggested to subscribe to these shares carefully once you are confident about the company’s future.
4. Stock Split
As the name suggests, a stock split means splitting a stock into two more equal portions. They work on the same principles as bonus issues. Stock splits are normally announced by companies so that they can make their shares affordable to small retail investors and hence makes them more liquid.
The number of shares with shareholders increases after a stock split however the investment value remains the same. Let’s understand it with a suitable example: A company declares a stock split of 1:2. If the face value of the stock is Rs. 10. Before splitting, you held 25 shares, and after the split, you will hold 50 shares. The face value will change to Rs. 5 per share, hence the total investment value of Rs. 250 intact.
It is an event when a company buys its shares from its shareholders to consolidate its stake in the enterprise. Before you participate in buyback opportunities, ascertain the reasons why a company is doing it.
Understanding the effects of corporate actions is important to evaluate a company’s worth. A rights issue may drive the share price down while buyback of shares may create a sudden spike in the share price. Analysts and stock experts, therefore, carefully inspect these corporate actions and try to figure out the stock prices and their upcoming performances in the future.