Rick Welch: Dollars and $ense
Understanding Corporate Actions
A corporate action is an event or action taken by a publicly traded company which can impact its stakeholders, including its shareholders, bondholders and employees. These actions are typically approved by the company’s board of directors and, in some cases, require authorization by shareholders. There are many types of corporate actions which, under the scope of corporate governance, are initiated some with great fanfare and others within the ordinary course of business. Some actions are compulsory, while others provide for the elective participation of the shareholders. Some actions, like spin-offs, stock splits and share repurchases or buybacks can offer interesting opportunities for the investor. In understanding these types of corporate actions, an investor can have a clearer picture of what the action indicates about a company’s financial affairs and how that action may influence the company’s future share price and performance.
A spin-off is an example of a corporate action intended to restructure the company. A spin-off is a sale or divestiture of a subsidiary company or division to create a new, independent entity. Shares of the new company are distributed to the shareholders of the parent company in accordance with a specific ratio. The new shares, just like the shares owned in the parent company, may be kept or sold by the shareholders at their discretion. The theory behind most spin-offs is to unlock hidden value, which value is not fully reflected in the parent company valuation, so splitting the business allows the market to properly value each part. In some cases, a spin-off allows the parent company to focus on its core competencies while providing an opportunity for the new company to be a bit more nimble, entrepreneurial and aggressive in building its business free of the constraints of operating within a larger, more diverse organization.
As defined, a “stock split is a corporate event which increases the number of a company’s shares, while simultaneously reducing the per share price, such that the market capitalization of the company remains the same before and after the event.” The shares of a company are increased or multiplied by an adjustment factor (say 2 for 1), while the price is decreased or divided by the same factor. In this case, an investor who holds 10 shares of a stock priced today at $100/share, after a 2 for 1 split would hold 20 shares of the same stock now priced at $50/share. Most splits are approved as a means to influence the share price and spur investor demand, both objectives which are rooted in the widely held belief that share prices between $20 and $50 are considered both affordable and more desirable for investors.
There can be a variety of reasons behind the announcement by a company of a stock buyback or repurchase plan. By purchasing outstanding shares of its stock, a company can improve key ratios like earnings per share (EPS), return on assets and return on equity. In the case of improved EPS, this ratio benefits from having the same amount of earnings divided by a smaller amount of outstanding shares. Share buybacks can also be used to cover employee stock option plans (EPS dilution occurs when stock options are exercised) and to thwart an unfriendly corporate takeover. While some financial engineering may be beneficial, what buybacks often suggest is that the company has no other viable capital need (new plant or equipment, more product development, increased hiring, etc.) by which it could continue to grow its business. What the investor must decide is if this use of surplus cash is the best use of this corporate asset or if the “we do not know how to grow our business” theme is a more cautionary one.