When a publicly-traded company issues a corporate action, it is initiating a process that will bring actual change to its stock. By understanding these different types of processes and their effects, an investor can have a clearer picture of what a corporate action indicates about a company's financial affairs and how that action will influence the company's share price and performance. This knowledge, in turn, will aid the investor in determining whether to buy or sell the stock in question.
Corporate actions are typically agreed upon by a company's board of directors and authorized by the shareholders. Some examples are stock splits, dividends, mergers and acquisitions, rights issues and spin offs. Let's take a closer look at these different examples of corporate actions.
As the name implies, a stock split (also referred to as a bonus share) divides each of the outstanding shares of a company, thereby lowering the price per share - the market will adjust the price on the day the action is implemented. A stock split, however, is a non-event, meaning that it does not affect a company's equity, or its market capitalization. Only the number of shares outstanding change, so a stock split does not directly change the value or net assets of a company.
A company announcing a 2-for-1 (2:1) stock split, for example, will distribute an additional share for every one outstanding share, so the total shares outstanding will double. If the company had 50 shares outstanding, it will have 100 after the stock split. At the same time, because the value of the company and its shares did not change, the price per share will drop by half. So if the pre-split price was $100 per share, the new price will be $50 per share.
So why would a firm issue such an action? More often than not, the board of directors will approve (and the shareholders will authorize) a stock split in order to increase the liquidity of the share on the market.
The result of the 2-for-1 stock split in our example above is two-fold: (1) the drop in share price will make the stock more attractive to a wider pool of investors, and (2) the increase in available shares outstanding on the stock exchange will make the stock more available to interested buyers. So do keep in mind that the value of the company, or its market capitalization (shares outstanding x market price/share), does not change, but the greater liquidity and higher demand on the share will typically drive the share price up, thereby increasing the company's market capitalization and value.
A split can also be referred to in percentage terms. Thus, a 2 for 1 (2:1) split can also be termed a stock split of 100%. A 3 for 2 split (3:2) would be a 50% split, and so on.
A reverse split might be implemented by a company that would like to increase the price of its shares. If a $1 stock had a reverse split of 1 for 10 (1:10), holders would have to trade in 10 of their old shares for one new one, but the stock would increase from $1 to $10 per share (retaining the same market capitalization). A company may decide to use a reverse split to shed its status as a "penny stock". Other times companies may use a reverse split to drive out small investors.
There are two types of dividends a company can issue: cash and stock dividends. Typically only one or the other is issued at a specific period of time (either quarterly, bi-annually or yearly) but both may occur simultaneously. When a dividend is declared and issued, the equity of a company is affected because the distributable equity (retained earnings and/or paid-in capital) is reduced. A cash dividend is straightforward. For each share owned, a certain amount of money is distributed to each shareholder. Thus, if an investor owns 100 shares and the cash dividend is $0.50 per share, the owner will receive $50 in total.
A stock dividend also comes from distributable equity but in the form of stock instead of cash. A stock dividend of 10%, for example, means that for every 10 shares owned, the shareholder receives an additional share. If the company has 1,000,000 shares outstanding (common stock), the stock dividend would increase the company's outstanding shares to a total of 1,100,000. The increase in shares outstanding, however, dilutes the earnings per share, so the stock price would decrease.
The distribution of a cash dividend can signal to an investor that the company has substantial retained earnings from which the shareholders can directly benefit. By using its retained capital or paid-in capital account, a company is indicating that it can replace those funds in the future. At the same time, however, when a growth stock starts to issue dividends, the company may be changing: if it was a rapidly growing company, a newly declared dividend may indicate that the company has reached a stable level of growth that it is sustainable into the future.
A company implementing a rights issue is offering additional and/or new shares but only to already existing shareholders. The existing shareholders are given the right to purchase or receive these shares before they are offered to the public. A rights issue regularly takes place in the form of a stock split, and can indicate that existing shareholders are being offered a chance to take advantage of a promising new development.
Mergers and Acquisitions
A merger occurs when two or more companies combine into one while all parties involved mutually agree to the terms of the merge. The merge usually occurs when one company surrenders its stock to the other. If a company undergoes a merger, it may indicate to shareholders that the company has confidence in its ability to take on more responsibilities. On the other hand, a merger could also indicate a shrinking industry in which smaller companies are being combined with larger corporations. For more information, see "What happens to the stock price of companies that are merging together?"
In the case of an acquisition, however, a company seeks out and buys a majority stake of a target company's shares; the shares are not swapped or merged. Acquisitions can often be friendly but also hostile, meaning that the acquired company does not find it favorable that a majority of its shares was bought by another entity.
A reverse merger can also occur. This happens when a private company acquires an already publicly-listed company (albeit one that is not successful). The private company in essence turns into the publicly-traded company to gain trading status without having to go through the tedious process of the initial public offering.Thus, the private company merges with the public company, which is usually a shell at the time of the merger, and usually changes its name and issues new shares.
A spin off occurs when an existing publicly-traded company sells a part of its assets or distributes new shares in order to create a newly independent company. Often the new shares will be offered through a rights issue to existing shareholders before they are offered to new investors (if at all). Depending on the situation, a spin-off could be indicative of a company ready to take on a new challenge or one that is restructuring or refocusing the activities of the main business.
It is important for an investor to understand the various types of corporate actions in order to get a clearer picture of how a company's decisions affect the shareholder. The type of action used can tell the investor a lot about the company, and all actions will change the stock itself one way or another.