Much debate exists around the pricing of rights issues, which are routinely used by companies as a way to raise money. As an existing or new shareholder of these companies, it is important to remember that the price of the rights shares is completely irrelevant to the attractiveness of the investment.
There are some transactions that happen frequently between a company and its shareholders, broadly called “corporate actions". These are classified into three broad areas. One, actions the company undertakes to transfer money to shareholders. Two, actions to take money from shareholders. And three, actions that have no economic relevance.
Since a company is funded by its shareholders, they have to be paid back, typically done through declaring dividends. When the company makes profits, its managers decide how much of that should be shared with the providers of capital and how much should be set aside to grow the business. Managements spend a lot of time deciding this number because it’s not common to keep it fluctuating. Most importantly, this way of distributing profits is non-discriminatory to shareholders unlike the other option, a buyback.
Since buyback is voluntary, shareholders who decide to tender their shares end up getting the present profit share back entirely. Others end up owning more of the future profit share. Unlike dividends, this way of distributing profits is not uniform. If a company buys back at a price higher than what it is worth, the selling shareholders have made a smart decision. But when it buys back below what it is worth, the residual shareholders are the smarter ones.
Mathematically, dividends are buybacks done at an infinite price. Taxation makes buybacks more efficient than dividends from the company’s perspective—the former are taxed lower than the latter.
The second form of corporate actions is when a company decides to raise money. This, too, can be done in a uniform way or otherwise. One way is to raise money from a few (including new) but not all shareholders. An initial public offering or a qualified institutional placement falls into this bracket. If a company can raise capital by pricing such issues at levels higher than what they are worth, it is beneficial for existing shareholders. But if issues are priced lower than what they are worth, it is detrimental to existing shareholders. Hence, in this form of capital raising, pricing of fresh shares is critical just like when the opposite happens by way of buyback. Pricing, though, becomes irrelevant when done by a rights issue.
A rights issue is an entitlement given to the existing shareholder to invest more money in the company. Each share has the same right, just like dividend. The ownership of the company does not change pre- and post-rights issue. Hence, the price at which new shares are issued is irrelevant. Here’s an illustration to clarify this. Imagine a company having 100 shares owned by two shareholders in the proportion of 90 and 10. The company wants to raise 1,000 by way of rights issue. If it prices the rights issue at 100, it would issue 10 new shares. The resulting number of shares would be 110, of which 99 would be owned by one shareholder, and 11 by another. Had the company priced the issue at 10, it would mean 100 new shares, and resulting shares would be 200 of which 180 would be owned by the majority owner and 20 by the minority owner. So, from an economic point of view, in both scenarios nothing changes except the share count. The company got 1,000 in both cases; the ownership ratio did not alter, which means the share of future profit will be similarly divided as it was in the past. Whether an owner owns 99 shares of 110 or 180 of 200 is irrelevant, because the percentage ownership remains exactly the same. What, of course, is relevant is how the 1,000 is used by the company. If it is used astutely, shareholders will benefit, else they will lose. The numerical share count and consequently the price of the issue in no way influences the economic value of the firm.
This brings us to the third set of corporate actions—bonus issues or splits. These probably attract the most headlines but are entirely irrelevant to the value of the firm (or even to all the shareholders combined). They are akin to replacing a single note of 100 in a wallet with 10 notes of 10. Only in the stock market is this action taken to mean that the value in the wallet has increased. Mathematically, these can be treated as a rights issue at zero price. No money accrues to the company and no changes happen to the ownership structure, so these actions have no economic meaning.
Some argue that bonus issues or splits have signalling value whereby such actions reflect management optimism. There is no empirical evidence to back this statement. In fact, since these actions involve no money transfer, they can and are often abused, trapping unknowing shareholders. If the management is confident of the future, the best way to show it is by putting its money where its mouth is and buying back its own stock or raising dividends.
Some others argue bonus shares have tax benefits for the individual. This is true only if one ignores the opportunity cost of holding on to the residual shares and tax incidence on the shareholder who is selling and buying from the individual. Simplistically put, individuals can take advantage of taxation rules but the whole system cannot increase its own economic value by merely declaring bonuses.
The final argument is that a rights issue helps increase liquidity; in other words, the shareholders keep changing. Need one say more of a management that does not want long-term shareholders?
(Company law-related attributes of the corporate actions have been ignored as the focus was economic value creation.)
Huzaifa Husain is head-equities, PineBridge Investments.