When a publicly-traded company issues a corporate action, it is doing something that will affect its stock price. If you're a shareholder or considering buying shares of a company, you need to understand how an action will affect the company's stock. A corporate action can also tell you a great deal about a company's financial health and its short-term future.
Corporate actions include stock splits, dividends, mergers and acquisitions, rights issues and spin-offs. All of these are major decisions that typically need to be approved by the company's board of directors and authorized by its shareholders.
The Stock Split
A stock split, sometimes called a bonus share, divides the value of each of the outstanding shares of a company. A two-for-one stock split is most common. An investor who holds one share will automatically own two shares, each worth exactly half the price of the original share.
So, the company has just cut its own stock price in half. Inevitably, the market will adjust the price upwards the day the split is implemented.
The effects: Current shareholders are rewarded, and potential buyers are more interested.
Notably, there are twice as many common stock shares out there than there were before the split. Nevertheless, a stock split is a non-event, because it does not affect a company's equity or its market capitalization. Only the number of shares outstanding changes.
Stock splits are gratifying to shareholders, both immediately and in the longer term. Even after that initial pop, they often drive the price of the stock higher. Cautious investors may worry that repeated stock splits will result in too many shares being created.
The Reverse Split
A reverse split would be implemented by a company that wants to force up the price of its shares.
For example, a shareholder who owns 10 shares of stock valued at $1 each will have only one share after a reverse split of 10 for one, but that one share will be valued at $10.
A reverse split can be a sign that the company's stock has sunk so low that its executives want to shore up the price, or at least make it appear that the stock is stronger. The company may even need to avoid getting categorized as a penny stock.
In other cases, a company may be using a reverse split to drive out small investors.
What Are Corporate Actions?
A company can issue dividends in either cash or stock. Typically, they are paid out at specific periods, usually quarterly or annually. Essentially, these are a share of the company profits that are being paid to owners of the stock.
A cash dividend is straightforward. Each shareholder is paid a certain amount of money for each share. If an investor owns 100 shares and the cash dividend is $0.50 per share, the owner will be paid $50.
A stock dividend also comes from distributable equity but in the form of stock instead of cash. If the stock dividend is 10%, for example, the shareholder will receive one additional share for every 10 owned.
If the company has a million shares outstanding, the stock dividend would increase its outstanding shares to a total of 1.1 million. Notably, the increase in shares dilutes the earnings per share, so the stock price would decrease.
The distribution of a cash dividend signals to an investor that the company has substantial retained earnings from which shareholders can directly benefit. By using its retained capital or paid-in capital account, a company is indicating that it expects to have little trouble replacing those funds in the future.
However, when a growth stock starts to issue dividends, many investors conclude that a company that was rapidly growing is settling down for a stable but unspectacular rate of growth.
A company implementing a rights issue is offering additional or new shares only to current 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 in any case 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 with all parties involved agreeing to the terms. Usually, one company surrenders its stock to the other.
When a company undertakes a merger, shareholders may welcome it as an expansion. On the other hand, they could conclude that the industry is shrinking, forcing the company to gobble up the competition to keep growing.
A reverse merger is also possible. In this scenario, a private company acquires a public company, usually one that is not thriving. The private company has just transformed itself into a publicly-traded company without going through the tedious process of an initial public offering. It may change its name and issue new shares.
A spin-off occurs when an existing public company sells a part of its assets or distributes new shares in order to create a new independent company.
Often the new shares will be offered through a rights issue to existing shareholders before they are offered to new investors. A spin-off could indicate a company ready to take on a new challenge or one that is refocusing the activities of the main business.