How corporate events impact stock prices!

By | September 2, 2011

We tend to ignore the basic fundamental of stocks when we invest. However small the ownership of the company, we tend to buy it! Every stock represents a tiny ownership of the company. This implies that the corporate events within the company will impact the stock. The purpose of a firm is to maximize the shareholders’ value and the management is delegated with the responsibility to achieve the same.

Hence management takes action, which essentially increases the wealth of the shareholders. This may not be true in many cases, but that’s beyond the scope of this article. While many fundamental actions within the company impact share prices, let’s examine 5 of these actions that have a direct impact on share prices.

Announcement of Dividends

Dividends are part of the profit that the company distributes among its shareholders.

The impact of dividend depends on the amount of dividend declared by companies in proportion to the stock price. In a perfect market, share prices should go down by the amount of dividend declared. However, this may not happen in reality. If the dividend declared is too low (below 2% of the price), the prices do not change much. However, if the dividend is significant, the prices fall by approximately the dividend amount.

Sometimes, announcement of dividend increases the share price in the short term as everyone wants to possess the stocks to get dividends. However, this is a temporary phenomenon. The ex-dividend prices go back to old prices that are even lower by the dividend amount.

Buy Back of Shares

Buy back is a confidence boosting measure by corporates where the company buys back their own shares from the open market, usually at a higher price than the existing market price. Nobody will sell the stock at a lower price than the market price. Moreover, if the management decides to buy back the shares at a lower price, it will only show that the company doesn’t think its shares are worth even the market price.

Many companies buy back their own shares to show confidence in the company and also to correct the prices as sometimes the prices are unreasonably beaten down. Buy back reduces the number of shares and hence increases the earnings per share, which impacts share price positively.

Stock Split

Stock split is an event when company splits a share into 2 or more. This happens when company thinks that its shares are very expensive (different from over-valued), and investors are finding it hard to invest the kind of money it requires. For example, MMTC was trading at a price of Rs 25000+ at one time in the past. Many retail investors found it hard to invest in such a huge amount in MMTC shares. This got split and now the price is at 600+. Investors can afford it now. In fact the number of investors has increased after the shares got split.

Splitting share enables many retail investors, who could not invest because of a high price, to invest and take advantage of a low price. This increases the demand of the share and hence price. Investors should note, however, that splitting doesn’t change the fundamentals of the company.

There is also the reverse of this process, known as reverse stock split, which involves combining two or more shares of a company into one share.

Launching the Rights Issue

If a company needs additional capital, it launches rights issues. In this issue, existing shareholders are given first right to buy the issue. Only when the existing shareholders refuse to buy the rights issues, this is offered to others.

It is advisable to buy the right issues if investors own the shares. Usually after the rights issue, share prices go down. The reason the lower prices of rights issue compared to the existing market price. The company cannot keep the price higher or same as existing market price because then there is no incentive to buy rights issue.

Mergers & Acquisition

This is one of the most high risk corporate actions. Many times, the intended objective of a merger and acquisition is not reached. In fact failed mergers are a norm. If the mergers and acquisition creates synergy between the acquirer and acquired, the share prices will go up. Market will treat the event positively. However, if market senses foul play or bad decision, it will treat the stock ruthlessly.

Usually, the acquirer pays premium to the acquired company’s shareholders. Hence the price of the target of acquisition goes up in the short term.

Why keep a watch on stock prices?

The answer is obvious ofcourse. You need to monitor the prices inspite of the logic that you just need to let your shares accumulate wealth in the long term for 10-15 years to reap the best benefits! Of course you need to do that but that does not mean you ignore to keep a watch on the prices. What if you plan to use the profits from your shares to time the down payment for your home loan or plan to buy a car without opting for a car loan – if you do not keep a watch on the prices,  the investment could prove useless to you in the hour of need.

Conclusion

Corporate actions are a good way to gauge the impending performance of the company and also the competence and intent of management. Investors should keep an eye on such announcements as there is always the information gap in the market in the short term and shrewd investors can exploit this gap.

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