Module for Investors
From Spectator to Shareholder
5. How do Dividends, FPOs and Rights Issues impact stock prices?
Investment can be difficult if you are not aware of the right terms and their meanings. You need to be directed with guidance to make profitable decisions in time. In this chapter, we will cover Right Issue, Dividends and FPO to set the right foundation for you.
What is a Rights Issue?
An invitation to the existing shareholders for purchasing additional new shares in the company is called the right issue. The company in which you hold shares invites you to buy more of its shares is the right issue. This type of issue will give a shareholder a chance to purchase new shares at a discount to the market price on a mentioned date in future. By doing so, the company is allowing its shareholders to get hold of the shares at a discounted price.
As a shareholder, you may trade the rights in the market the same way you would trade any ordinary shares until the date at which the new share can be purchased. The rights issued to you have a value, which means that you will be compensated for the future dilution of your existing shares’ value. Now the question arises why would there be a dilution? The answer is that the dilution happens because now when a company is offering rights, its new profit will spread over a larger number of shares. The earning per share or EPS of the company decreases because the allocated earnings result in the share dilution.
Why does a company issue a rights offering?
Most commonly, companies issue rights offering to raise additional capital. When a company needs extra capital to meet its current financial obligations, it issues rights offering. A situation where a company is unable to borrow money and has to pay down debt, it may use a rights issue for this purpose.
It is not that a company under debt will only raise money through a rights issue. Companies which have healthy balance sheets might also issue rights to raise money. The reasons for doing so can be many. The company may have to acquire a competitor or open a new facility. For you, as a shareholder, this can create capital gains.
So, it is not that a company which sells rights offering is in financial trouble. The companies with a clean balance sheet might also do this. Therefore, even if your outstanding shares are diluting due to rights offering, there are chances that the increased capital to fund expansion will lead to an increase in the capital gain for the shareholders.
How rights issues work
Let us answer this question for you. Let's say you own 1,000 shares in XYZ Telecom and each of which is worth Rs 10.50. Now, XYZ Telecom is in financial trouble and needs to raise cash so that it can cover its debt obligations. XYZ Telecom, therefore, announces a rights offering. Through a rights offering, it plans to raise Rs 30 Crore by issuing 10 crore shares to existing investors for Rs 3 each. But this issue is a three-for-10 rights issue. In other words, for every 10 shares you hold, XYZ Telecom is offering you another three shares at a deeply discounted price of Rs 3.
Now, as a shareholder, you get three options with a rights issue. Let’s understand these.
1. Take Up the Rights to Purchase in Full
You can take up the rights to purchase in full. What does that mean? It means that to the benefit of the rights issue in full, you would need to spend Rs 3 for every share which XYZ Telecom is offering. Now when you hold 1,000 shares, you can buy 300 new shares to make it three shares for every 10 you own at a discount of Rs 3 for the price of
To take advantage of the rights issue in full, you would need to spend Rs3 for every XYZ share that you are entitled to purchase under the issue. As you hold 1,000 shares, you can buy up to 300 new shares (three shares for every 10 you already own) at the discounted price of Rs 3 for a total price of Rs 900.
With the introduction of new shares at a significantly discounted price, the value of the share will decline. However, you must remember that the loss on the existing shares which you have will be offset by gains in share value on the new rights.
2. Ignore the Rights Issue
You also have an option to not invest in the rights issue. You can choose to ignore it and let your rights expire. Experts do not recommend this. Even if you decide to do nothing, your shareholding will still be diluted because the company is issuing extra shares, regardless of your actions.
3. Sell Your Rights to Other Investors
Not in every case, the rights are transferable. They are called non-renounceable rights. But in the case where your rights permit you to decide if you want to buy the shares or sell your rights to an investor or the underwriter. In such a case, the rights can be traded and are called renounceable rights. After you trade the rights, they are called nil-paid rights.
After understanding the rights issue, let us also give you an insight into dividends and how they can make a difference.
A company pays dividends to its shareholders for distributing profits. The company denotes the corporate health and earning growth to its investors by dividends. The dividends can affect the underlying stock in several ways—the history of the dividend judges the popularity of a given stock. The market price is affected by the declaration of payments of dividends.
How Dividends Work
Dividends are a popular source of investment income for investors. The issuing company uses dividends to redistribute profits to shareholders as a goodwill gesture to thank them for their support. Dividends also symbolise the company's success. That is because the dividends are issued from a company's retained earnings. The substantially profitable companies issue dividends with any consistency. The amount you receive as an investor is dependent on your current ownership stakes.
The Effect of Dividend Psychology
Dividends impact the psychology of investors. Dividends are the deciding factor when it comes to investments by many. With investors, the stocks that pay consistent dividends are most popular. Companies find themselves in a good position on generously rewarding the shareholder with consistent and increasing dividends each year. Let’s say, your friend has invested in the stocks of a company. He is buy-and-hold investors who benefit from the payments of dividends. He finds this company financially stable because it pays him dividends. Now, you as an investor are also influenced and want to invest in the same company. This is how dividends impact the psychology of investors. When more investors buy in to reap the benefits of stock ownership, the stock price increases naturally. This makes people believe that the stock of this company is strong.
On the contrary, when a company which is in good books of people for paying dividends issues a lower-than-normal dividend or no dividend at all, it may be considered as a sign that the company is having a hard time. It may or may not be true. The case can be that the company is using its profits to expand itself further. However, what the market perceives is stronger than the reality and it further influences the investors. This is why many companies pay dividends on time to avoid any straddling investors.
What is the effect of a Dividend Declaration on Stock Price?
The issuing company declares a date before distributing the dividends. It also declares the amount of dividend it will distribute. Also, an ex-dividend date is announced which is the last date to buy shares to receive the dividend.
What effect does the dividend declaration have on stock price? The declaration encourages investors to purchase the stock. Now when the investors are aware that they will receive the dividends if they purchase the stock on time which is the ex-dividend date then they are willing to spend on paying a premium. This leads to an increase in the stock price in the days closer to the ex-dividend date. However, the increase is about the amount equal to the dividend. The price change is not defined by a governing entity, rather it is based on market activity.
It can be a case that the investors drive down the stock price by the amount of the dividend on the ex-date. This is possible if investors are not in a position to pay the premium which makes them ineligible to receive the dividends. In the case where the market is positive about the leading up of the stocks up to the ex-dividend date the increase in price which it creates might be larger than the actual amount of the dividend. This causes a net increase in amount irrespective of the automatic reduction.
Same as cash dividends, the stock dividends do not actually increase the value for investors at the time of issuance. The price of the stock increases once the dividend is declared.
The stock dividend increases the number of shares which are outstanding. However the value of the company remains stable, it dilutes the book value per common share which leads to a decrease in stock price accordingly.
Dividend Yield/Payout Ratio
How would you evaluate companies as an investment for the dividend income? There are two valuation ratios- dividend yield and dividend payout ratio (DPR).
- Dividend ratio- It shows the annual return per share. As an investor what you the dividend investment return per rupee invested is calculated using dividend ratio. It is expressed as a percentage. The formula to calculate it is:
- The dividend yield shows the annual return per share owned that an investor realizes from cash dividend payments, or the dividend investment return per dollar invested. It is expressed as a percentage and calculated as:
- Dividend Payout ratio- This ratio is considered more beneficial for evaluating the financial condition and prospects of a company for maintaining or growing its dividend payout. The formula to calculate the dividend payout ratio is:
Dividends Per Share (DPS)
The amount of profit which a company pays out to its shareholders over a year on a per-share basis is called dividends per share. You can calculate the DSP by subtracting the special dividends of the sum of all dividends over a year and the by dividing it by outstanding shares.
Dividend Discount Model (DDM)
Now let us also look at the dividend discount model. The dividend discount model is used for estimating the price of a company’s stock. Now the question arises that how does the DDM work? If the present value which is calculated under the DDM is higher than the current trading price, then stock qualifies for ‘buy’ decision because it is undervalued.
Follow-On Public Offering (FPO)
Issuance of stock shares followed by a company’s initial public offer (IPO) is called a follow-on offering. Follow-on offering is of two types- diluted and undiluted. Let us understand the difference between them:
- Diluted follow-on- When a company issues new shares after the IPO, the company’s earning per share decreases. This is diluted follow-on.
- Non-diluted follow-on- When the shares which come into the market already exist and the EPS remains the same, it is non-diluted follow-on.
Whenever a company plans on offering additional shares, it must register the FPO offering and provide the regulators with a prospectus.
How does a Follow-On Offering (FPO) work
An initial public offering is based on the health and performance of the company and also the price which the company targets to achieve during the IPO. The market drives the follow-on offering. Investors have a fair chance to value the company before buying because the stocks are already traded publicly. The investments banks working on the offering will focus more marketing efforts than on valuation. Thus, the follow on share price tends to be at a discount to the current, closing market price.
The process of FPO impacts share prices in the market. Most of the time, FPO pushes the stock price lower because of the dilution. This means that the proportionate decrease in the central value of each stock. At the same time, the reduction in existing shareholders' ownership of a company as a result of the issuance of additional shares.
For example, if an investment company XYZ owns 10,000 unit shares of a listed company ABC with 100,000 units of shares outstanding, the existing ownership of company XYZ is 10 percent. If ABC comes up with 50,000 units of FPO, then after the offering, the percentage of ownership of the company X will decrease to 6.67 per cent only. Likewise, EPS, the best performance measure of the company, would also have similar dilution effects. The similar effect will appear in other accounts parameters. The increase in numbers of shares outstanding results in the decrease in Earning per Share (EPS) which leads to an increased Price Earnings (P/E) ratio, the most crucial investment indicator many investors base their investing decisions.
The reasons why companies perform follow-on offerings can be many. The company might need additional capital to finance its debt or to refinance debts when the interest rate is low. It may also do it to make an acquisition. You should be aware of the reasons that a company has for a follow-on offering before putting your money into the company.
- An invitation to the existing shareholders for purchasing additional new shares in the company is called the right issue.
- Companies issue rights offering to raise additional capital or to meet its current financial obligations or to to fund expansion and acquisitions.
- A company divides and distributes profit to its shareholders as dividends.
- The stocks that pay consistent dividends are popular and impact the psychology of investors.
- The declaration encourages investors to purchase the stock.
- The price of the stock increases once the dividend is declared. The stock dividend increases the number of shares which are outstanding.
- The amount of profit which a company pays out to its shareholders over a year on a per-share basis is called dividends per share.
- Issuance of stock shares followed by a company’s initial public offer (IPO) is called a follow-on offering.
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The perfect starter to begin and stay tuned with your learning journey anytime and anywhere.