You’ve bought some shares for your long term portfolio and one day you receive paperwork from the company announcing a Share Buyback or a Rights Issue.
What issues should you consider when deciding to participate in these corporate actions?
A buy back by a company is a way for a company to invest surplus funds in themselves by buying back existing shares from shareholders. They may want to increase the value of shares still available by reducing supply or perhaps to rule out threats by larger shareholders who may be preparing themselves for a controlling stake in the company.
Share buy backs can either occur on the open market over an extend period of time or through a tender offer where shareholders nominate some or all of their shares to be bought back.
One by-product of share buybacks is that a couple of the more popular fundamental ratios can increase. Return on assets will increase because with cash going out to buy the shares, the assets side of the equation will decrease. Return on equity will also increase as there is less equity on the company’s balance sheet as a result of the share buyback.
One major advantage to shareholders can often be the tax effectiveness of share buybacks. Often buy backs will come with franking credits which of course will have different benefits depending into which tax bracket you fall.
To gain a better understanding of how share buy backs work in practice, explore this detailed post on the AIA forum at: 2010 BHP share buyback.
When a company needs new capital, one way they can raise money is to sell more shares to existing shareholders. This is called a share rights issue as only existing shareholders will have the ‘right’ to buy the new shares.
Rights issues can be used by companies who are cash strapped and who need to cover debt or by solid companies with clean balance sheets to fund acquisitions and growth.
Having an understanding of the reason why a company is undertaking a Share rights issue is the first step in deciding what to do.
Generally, rights issues are made at a price that is less than the company’s current share price so that the rights issue is attractive to shareholders.
Rights issues can take many formats but the two most common are:
- pro-rata e.g. for every 10 shares you hold, you have the right to buy 1 new share
- a set dollar amount or number of shares.
Sometimes shareholders can sell the ‘right’ to buy the new shares on the stock market. This is called a renounceable rights issue. If rights can’t be sold and they must either be taken up or lapse then this is called a non-renounceable rights issue.
One thing to keep in mind is that whether you take up the rights issue or not, as an existing shareholder the value of your shareholding will be diluted by the issuing of shares at a reduced price. This dilution is different in every case so you should do your own research and consider each share rights issue on its own merits.
Investopedia has an article which crunches some numbers in an excellent case study which explores the options for shareholders.
The Intelligent Investor site has a great explanation of a past rights issue from 2006 relating to Roc Oil. Well worth a read to gain an understanding of how Share Rights issues may affect share prices.
Bonus issues also mean that company’s are issuing new shares but generally bonus issues are free to shareholders. While this corporate action increases the number of shares owned by an individual shareholder, generally it does not increase the total value of the shareholding as the ratio of the number of shares held to the number of shares outstanding remains the same.
Companies may decide to issue bonus shares as an alternative to increasing a dividend. Generally a result of issuing bonus shares will be a dilution of equity but often share prices don’t fall significantly and bonus issues are taken as a sign of good health of the company.