Corporate actions explained

What you’ll learn:

• What corporate actions are
• The difference between mandatory and voluntary corporate actions
• The financial implications of corporate actions.

There are lots of things a company can do in the marketplace that will affect its share price. Some actions will move prices in a positive way while others may result in a negative market response. Understanding what the common corporate actions are, and what they could do to the value of your investment, means you could be in a better position to respond in a way that's right for you.

What is a corporate action?

There are two main types of corporate action – mandatory and voluntary. A mandatory action is started by the company's board of directors. This could include, for example, mergers and stock splits. Shareholders don’t have to act on these actions but they’re affected as beneficiaries.

In contrast, a voluntary event occurs when shareholders elect to take part in an action. Here, the company can’t act without the shareholders' response. Examples of voluntary actions include events such as rights issues and open offers.

Main types of corporate actions

Conversion event

Companies often look to attract investors by issuing convertible shares or convertible preferred stock. The issue is made financially attractive to shareholders without giving away any control. So, if you hold preferred stock, you'll have limited or no voting rights, which means you won’t have any influence over the company's affairs or the directors making up the board. You do, however, have priority over other shareholders – who own what’s known as common stock – if the company is liquidated. The conversion element comes in when preferred stock is converted to common stock, which shareholders seek to do when there’s an appreciable rise in the value of common shares. The company can also issue convertible bonds as another means of raising funds and these operate in a similar way to preferred stock.

Rights issues

A rights issue, where companies offer shares at a special price to existing shareholders, could be a great opportunity to increase your shareholding in a firm. Companies turn to rights issues when they’re looking to raise money, maybe for expansion, or to pay down debt. New shares may be attractive to shareholders because they'll be cheaper than the current market price. However, shareholders aren’t obliged to buy them.

Know the reasons for the offer

Your decision to buy more shares should be made after you've found out the reason for the rights issue. If it's to pay off debt, it may be a sign that the company has cash-flow problems. Alternatively, if it's for expansion, you might think there's potential for greater profits to be made from this shareholding. If you don't feel qualified to make a judgement on the reasons, then get some professional advice.

Offering shares at a discount to the market price on a stated future date gives the company time to plan how much capital might be raised through the rights issue and gives shareholders time to get the investment sum together to buy. The number of new shares investors can buy is determined by the number of shares they already hold.

Appearances matter

An expiry date to buy these shares will be announced. After that time, any unsold shares will be made available to non-shareholding investors. Be aware that raising money in this way means that the company is essentially going cap in hand to the market. This may have a negative effect on the share price. Shareholders should also be aware that there could be some future dilution of their existing shares' value following a rights issue. This risk of dilution could be caused because more shares have been created in the act of making a rights issue – there has to be a strong demand to maintain the share price with more newly created shares becoming available.

Open offers

An open offer lets shareholders buy more ordinary shares in the company at a discounted price, in proportion to their existing holding. Entitlements from an open offer aren’t tradable, so its only available to existing shareholders. There will be only two options: take up your entitlement or let it lapse. If your entitlement lapses, you won’t usually receive any lapsed proceeds.

Stock splits

When a stock is split, a company increases the number of shares but their actual value doesn't change. If for example, you own 50 shares in a company at £10 per share, which gives you an investment valued at £500, then if the company were to announce a 2-1 stock split, you’d then own 100 shares each worth £5, which still means your investment is valued at £500.

This kind of mandatory corporate action won’t change the value of a company but could well change investors’ perceptions of the company.

Reasons for a stock split

A company that wants to attract new shareholders but feels that its share price is too high to do this, might arrange a stock split to lower the stock’s price, making shares more affordable.

The company is taking a gamble that a split will create demand for its shares. If the gamble pays off, it's good news for shareholders, as a surge in demand may push the price higher. But there are no guarantees and the market may react differently.

Investors will find that while their shareholding hasn’t decreased in value following a stock split, there’ll be a change to each share held. They may now own double the number of shares, but because the share price has been halved, this also means that each share is now entitled to just half the dividend, half the earnings, and half the assets. If you want clarification as to what a stock split will do to the overall worth of your shareholding, talk to a financial adviser.

Dividends

Dividends are payments made by a company to its shareholders out of its post-tax profits. These payments are not fixed, they move up and down like a company's share price. They can be paid once, twice, even four times a year, or a company can elect not to pay a dividend at all. A dividend paid mid-year is called the interim dividend because it's made alongside a company's interim report, which broadcasts the company's progress to date.

The board of directors is responsible for setting dividend payments and ideally aims for each dividend payment to be an improvement on the previous year or, at least, not to dip below.

There’s usually strong investor demand for a company that has a consistently good track record of generous dividend payments. For long-term investors, achieving both an income from dividends and capital gain from the share price provides the best of both worlds.

Dividends in the form of shares

Dividends can be offered in the form of shares, commonly known as scrip dividends, rather than as a cash share of the profits. If a company announces a 10% dividend, for example, you'll get one new share for each 10 you hold.

Special dividends

A special dividend is a one-off event. It's usually announced when a company can pay a larger than normal dividend but doesn't want this to set a new benchmark for future payouts. For this reason, shareholders need to be aware that a special dividend has only a limited effect on share price.

A special dividend payment usually occurs when a company finds itself cash-rich from perhaps exceptionally strong company earnings, or it may have sold off part of the business and the board of directors wants to distribute the profits directly to shareholders.

Mergers and acquisitions

A merger occurs when two or more companies believe they'll succeed in an even bigger market if they combine forces.

A new company is created, combining the assets and operations of both former companies. Shareholders from both companies will be offered shares in the new company.

An acquisition (or takeover) is when one company takes over ownership of another. Investors can be nervous around an acquisition as this kind of corporate action may be viewed as hostile. When an acquisition has the backing of the work force and investors, it stands a better chance of success.

Companies making a takeover bid may make a tender offer to the public. This takes the form of an open invitation to all shareholders to tender their shares for sale, at a specified price during a specified time. To induce shareholders of the target company to sell, the company making the tender offer usually includes a premium over the current market price. A takeover doesn’t usually specify a minimum or maximum number of shares. Investors simply accept the takeover terms on all or part of their holding.

As with all corporate actions, either event could push share prices higher or cause a fall.

Spin-offs

A spin-off is when a corporation creates a separate firm from part of its existing business. A spin-off would usually result in existing holders receiving shares in the new company based on their existing holding – this would be a mandatory event and not something existing holders would have to apply for. As with all corporate actions, a spin-off can prompt a positive or negative market reaction. A good scenario might be that the business creating the new spin-off company is keen to launch the division's full potential through a whole new structure with independent management. A bad scenario would be if the company is just looking to sell off some of its assets and uses the spin-off option as the means to do this. A full probe behind the scenes is called for, before buying shares, and if you need help with such analysis, get some professional advice.

If you’re new to shares, or you’d like to brush up, read our introduction to shares.