Should I Buy Stock After A Reverse Split?

Trading stocks is trickier for common investors then we think, Short-selling, arbitrage profiteering, and investing in futures to make money even gets difficult. There are Stock Market Analysts, Broker, and agents who carry out specialized tasks for investors on stock studies.

Seeking specialists’ advice is never cheap, for a common investor that might be costly then the “spread” they wish to take advantage of.

Companies take drastic steps to improve performance from time to time, one of such tactics is a reverse stock split option. Often considered as a last resort for many ailing firms…

A reverse stock split is a total opposite to the forward or common stock split, where the company BOD decides to limit the total number of outstanding shares.

It is often calculated in large ratios of 1 for 5, and 1 for 10, so a shareholder having 10,000 shares before a reverse will hold 1,000 new shares after a 1 for 10.

A reverse stock split increases the share price as the number of outstanding shares decreases. In a few cases, small shareholders having a low number of shares (100 or fewer shares) may lose their shares with the new share percentages. Like a forward stock split, the total market capitalization of the company remains the same.

As an investor, before you decide on whether a reverse stock split is good for you, know the reasons for a reverse stock split:

  1. It is often performed to increase the share price of the company
  2. A consolidated share price would attract more investors
  3. It is performed to save the company from delisting, as a lower stock price or a penny stock gets delisted from stock exchanges
  4. SME’s listed at Over-the-counter markets may perform the reverse stock split to increase the share price sharply and get listed on the stock exchange

So as an investor, if the company performs a reverse stock split, should you go for it? Stock prices get more affected by Stock market analysis, signals, and reputation than the actions such as a stock split.

If the management decides to perform a reverse stock split to stabilize the market share price, it generally is perceived as a good action by the analysts.

If you dig deep into the company financials, the reason for reverse stock splits is often connected with the poor financial health of the company. In that case, the management performs the tactics to save the company from delisting, which further damages its ailing reputation.

Remember, a reverse stock split is different from a stock buyback, which is a strong performing action for large firms. A large and successful firm is highly unlikely to opt for a reverse stock split; they often chose the buyback option.

Most investors take a reverse stock split as an accounting entry or as a smokescreen signal from the management, as they do not see any gains in the decision.

Penny stocks are traded at over-the-counter markets, growing companies often opt for listing at OTC markets as listing in the stock exchanges require substantial efforts and costs.

Growing companies may perform a reverse stock split to consolidate the share price and meet the prerequisite for listing in the stock exchange.

The phenomenon is rare though, as for “growing” and well-performing companies the share prices get investors’ attraction and the demand increases the share prices anyway. In either situation, if a company is moving from OTC to the stock exchange with a reverse stock split, it is a highly favorable indication to invest in such stocks.

If the company performs a reverse stock split but doesn’t take any other corrective measures that caused the share prices to fell so low, it may be an unwise decision to invest in that stock.

If the management performs strategic corrective measures that can boost the company performance and subsequently performs a reverse stock split, the analysts may consider it is a positive signal.

Investors often lose money in a reverse stock split as the prices fluctuate drastically with the news. Stock market analysts call the reverse stock split action as the last resort before a company gets delisted, so the market signal adversely affects the share price to further slide.

As an investor, it may be an unwise decision to invest in a struggling stock, unless the company also takes other reforms to strengthen the company position. Though in accounting terms, the reverse stock split does not affect the company as the total market capitalization remains the same.

Stock Split: Why A Company Splits Stock?

In business, liquidity is often a greater challenge than achieving profitability. For listed corporations it might be an even bigger headache, the most widely quoted answer to why companies opt for the stock split is to increase the liquidity.

There are several other reasons for a listed company opting for stock splits, and as to what are the implications of this decision on all stakeholders.

A stock split is simply an increase in the number of shares outstanding. For example, if a listed company has 1 million shares outstanding, and it announces a stock split, the total number of shares will increase depending on the decided ratio.

A stock split may take two forms; a forward stock split and a reverse stock split. In general, a stock split is often termed as a forward stock split in which the listed company increases the outstanding shares, so we’ll take on the topic from here on about the forward stock split.

How does it happen?

A company may decide any ratio for a stock split e.g. a 2 for 1, 3 for 1, 5 for 1, etc. Simply, a 2 for 1 split means if the previous number of shares were 1 million it will now be 2 million and so on.

All shareholders keep their new number of shares in the ratio decided, so their voting rights do not get affected. Also for the company as a whole, once the stock split happens the share price falls but the total market value of or capitalization does not change.

Prime Reasons of a Stock Split:

So if the market cap doesn’t change, who do companies opt for it?

  1. Increased number of shares brings the share price down; the company can control the market share price without any bad signaling effect.
  2. A stock split brings the share prices down that make it more convenient for common investors to buy the shares.
  3. In the long term, the share prices tend to increase generally which helps stabilize the market value of the shares.
  4. A lowered share price attracts more investors and hence enables the company to sell more shares and capitalize on liquid cash.
  5. A stock split may happen to satisfy existing shareholders, if the company is short of cash and instead of dividends the management may announce bonus shares in the form of a stock split.

In stock markets, a higher share price for a company means a successful company but often blue-chip firms reach a point where the share price is deemed too high.

That red flag makes it difficult for common investors to buy the shares as for large firms the number of outstanding shares is in billions.

The stock prices get affected by any news about the company, either performance-related or the strategic decisions from the BOD. When the management confidently decides for a stock split, it also gives a positive signal to the investors about the management confidence in future company endeavors.

Also as the total market capitalization doesn’t get affected, so the decision doesn’t make the shareholders unhappy about it. Either way, cash liquidity is the prime reason for most of the stock split decisions either for investing purpose or as a replacement for dividend cash.

Real-World Example:

Since its inception and listing publically with an IPO in 1980, the tech giant Apple Inc. has been through 4 stock splits. 03 of them were a 2 for 1 stock split, while the latest one in 2014, which was a 7 for 1.

Before the stock split, the share price for Apple reached a staggering $690 mark, and a 7 for 1 split meant the share price adjusted to $ 92.

For Equity Shareholders, the net effect of a stock split remains largely neutral, as it doesn’t affect their shareholding position, EPS, or Dividend payout ratio.

For day traders, often short selling or trading with Futures and options, the stock split also doesn’t affect adversely, as with the short-selling their number of increased shares will compensate for the reduced share price.

Importantly for common stockholders, the tax implications of the stock split are also neutral, as there is no excessive cash payout. The only drawback being the caveat (if attached) that new split stocks cannot be sold for a specific time period.

Large firms may have to opt for a stock split more than once, as controlling the share price is very important. From day traders to equity investors, a forward stock split presents no negative impact on their investments.

In the long term, however, the company reaps the reward of increased cash liquidity and frequent share trading.

Limitations of the Weighted Average Cost of Capital

The Weighted Average Cost of Capital (WACC) is the required rate of return on a business organization.

A business organization usually compares a new project’s Internal Rate of Return (IRR) against the organization’s WACC.

So, WACC is the minimum rate for an organization to accept an investment project. Despite many advantages, the WACC has many limitations also and they are described below:

  • The cost of equity and cost of debt is required to determine for calculating the WACC which is difficult to estimate for private companies due to lack of publicly available information. For public companies there are various methods for calculating cost of equity. There is no single formula that can be used in every company but assuming the cost of equity is difficult for calculating WACC.
  • The WACC carries an assumption that the debt to equity ratio will remain constant. For the forecasting value of a company, it is assumed that the WACC will remain constant and the debt to equity ratio will also remain constant. But it is impossible because the debt to equity ratio changes and so will the WACC.
  • The WACC can be lowered by increasing debts which will create problems. If debt is added beyond the optimal capital structure it will increase the present value of the cost of financial distress.

The WACC uses assumptions and there are problems with the assumptions. These are:

  • Profitability in a market is totally uncertain with changing demands, needs, competition and prices. It is required to consider the fact of understanding the return on that capital when determining the cost of capital. Because the profitability should exceed the cost of borrowing the fund.
  • Another important fact to consider is the opportunity cost which also changes over time. The cost of equity is made through identifying the risks of a particular project and comparing it with other similar projects. In this case the opportunity costs should be considered both for investors and the business itself.
  • A project has some unforeseen risks and for these risks capital is required that has not been considered in the forecast. When the amount of required capital increases, the financial risk also increases. So, more capital requirements during the project also increase the overall cost of capital.

WACC is highly sensitive to many factors. A company can control its capital structure. With an intension of making the cost of capital lower, a company can increase the level of debt. A company’s cost of capital is influenced by its investment activities.

When a company merges or acquires another company, the WACC will depend on sources of capital.

It is also the decision of management which sources of capital is suitable. A company cannot control economic factors such as inflation, so interest rates fluctuate.

A change in a company’s cost of debt also affects the tax rate which is imposed by a country’s fiscal policy. The term cost of equity also relies on the economy of the country because it depends on the market.

The Weighted Average Cost of Capital (WACC) is complex in its application due to the reasons such as the need to know the specific rate of return.

For determining the cost of equity, different methods can be used such as the dividend discount model, risk premium, CAPM model. There are inherent problems with each model because at least one of the variables can be an estimation.

For example, when using the Gordon growth model, the growth rate is an assumption and when using CAPM, the risk premium is an assumption using historical data. The risk-free rate and risk premium are used to estimate the cost of debt and there are also problems with both.

As the amount of debt increases a higher risk premium is required. It gets more difficult to estimate the company’s WACC depending on the company’s capital structure complexities.

The WACC is not suitable for accessing risky projects because to reflect the higher risk the cost of capital will be higher. Different people use different formulas to calculate WACC which gives different results and it also makes it difficult to accept WACC in some cases.

It can be stated at the end, WACC is important in the stock market for stock valuation. But the limitations are also necessary for investors to know whether the WACC will be helpful for them or not because forecasts are not sure things. However, this will also depend on the nature of the business.

Limitation of Dividend Valuation Models

There are some drawbacks of the Dividend Valuation Models which include factors like the difficulty of perfect projections and the assumptions of income from dividend.

Although the principle behind the model is simple but applying the theory is challenging. The limitations of Dividend valuation Models are described below:

  • The reality is that in some companies dividends grow over time and in some companies dividends will not grow at a specific rate until a certain period of time. Other companies may reduce their dividends or don’t pay at all. This means the model can be best applied only to those companies who have constant dividend payment policy.
  • The model can be used on those stocks that pay dividend. In most small organizations or start-ups, the model cannot be applied to determine their value as they are not in a position to pay dividend. Investors may miss a number of opportunities if they only focus on Dividend Valuation Model.
  • The model doesn’t consider non-dividend factors. There are many non-dividend factors like customer retention, intangible asset ownership, brand loyalty which can change the valuation of the company. Using a stable dividend growth rate when the model calculates the value it may not give expected result.
  • The model ignores the effects of stock buyback. Stock buybacks can have a significant impact on stock value when shareholders receive the return. This means the model is conservative in nature and using the model investors ignore other factors which can affect the final value of stock.
  • The model only values dividends as a return on investment. There are many ways of increasing portfolio by investing in stocks, bonds, mutual funds and other financial products. The model only looks at dividend stocks that means investor’s portfolio may not have the diversity that is required during a period of economic recession.
  • The model is very sensitive to the quality of information involved. The model’s success or failure depends on the inputs provided to it. When information is accurate, the valuation may be accurate. When assumptions used by investors are mostly accurate, they will find the model to be working properly.
  • When there are large variations in earnings and the maintenance of a stable dividend payout occurs, companies borrow money to ensure their status as a regular dividend provider. As the model assumes dividends are tied to earnings, in this case the model becomes worthless.
  • The model is prone to personal bias because investors use their personal assumptions and experience to value the stock. If an investor as a good viewpoint for a stock the valuation result will come good although the real picture is different. In this case, involving a third party to look over the information can be helpful.
  • There is a fact that the model is full of too many assumptions. The assumptions are the required rate of return, growth rate and tax rate. Most of the assumptions are not within the control of investors. So, this issue reduces the validity of the valuation model.
  • The model is not worthwhile in another sense that it does not take into taxation rules. In most of the countries tax structure is created in such a way that paying dividends is not advantageous from taxation perspective. For this reason, many companies choose to invest their profits back to their business. So, considering taxation rules the model fails to guide investors.
  • The Dividend Valuation model have limited use because it can only be used to mature and stable companies who pay dividends constantly. Investors generally invest in mature and stable companies and don’t focus on growing companies. Growing companies face lots of opportunities and want to develop in the future. For this purpose, they need more cash on hand and cannot afford paying dividends. Investors miss this companies because of the fact of not paying dividend.

The model is not applicable to large shareholders because they have a big shareholding and some degree of control and can influence the dividend policy. So, the model is not very useful for investors who are interested in investing in high risk-return companies.

Advantages of the Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is the rate expected to be calculated by a company in which each category of capital is weighted proportionately. Different types of sources which are included in the WACC calculation are bonds, common stock, preferred stock, warrants, options and other long-term debts. When calculating the present value of a project analysts use the WACC formula in financial modelling as the discount rate.

The WACC formula shows the relationships between the components of capital, equity and debt. The formula is:

WACC = E/ (E+D) * RE D/ (E+D) * RD * (1-T)

E = The market value of equity

D = The market value of debt

RE = The rate of return on equity

RD = The cost of debt

T = The tax rate

Advantages of WACC

The WACC is an important part of the Discounted Cash Flow (DCF) model and it’s a vital concept for finance professionals. It helps by giving a minimum rate a company should earn on its asset base to satisfy its stakeholders. Companies incur many types of costs and they want to reduce the costs. WACC suggests the costs companies incur on their capital that can be either debt or equity. WACC helps companies to increase their value because the lower the WACC, the higher will be the value of the firm.

  • WACC can be a measure for comparing similar business risks. It helps a company to know which corporation is incurring minimum costs in using its capital. The business risk indicates the possibility of generating less than the required profit. The business risk varies from industry to industry. When a company has lower WACC compared to other companies in the same kind of industry, it means it can create more value for its stakeholders.
  • WACC helps companies to make judgement whether to accept or reject a new project. To decide whether to accept or reject a project the IRR is compared with the cost of capital of the company.
  • As the WACC is the minimum rate a company should generate to meet the expectations of its stakeholders, so it acts as the hurdle rate for companies which they need to cross to generate values.
  • When evaluating mergers and acquisitions and preparing financial models the WACC is of great importance. Investment decisions should not be made when an IRR is below the WACC.

Analysts very often use the WACC to assess the value of investments and to choose from different types of investment opportunities. The WACC is an indicator of whether an investment decision should be made or not. If it is required to determine an investor’s personal return on an investment, the WACC should be subtracted from the company’s returns percentage. The WACC is also important in performing Economic Value-Added calculations. The WACC help in determining the amount of interest a company owes for each dollar it invests. A company’s capital funding comprises of debt and equity. Debt and equity holders expect a certain amount of return on the capital they have provided. The WACC indicate the return that both debt and equity holders expect to receive because the cost of capital is the return that both equity and debt holders expect to receive. In another sense, WACC is the opportunity cost for an investor for taking the risk of investing funds in a company. A company’s WACC is the overall required return for a company. For this reason, company directors often internally use WACC to decisions on different types of expansionary opportunities. The WACC is the discount rate which is used for cash flows for the risk that similar to the other business risks.

WACC is a metric that assists in the percentage distribution of costs for different amounts from different sources. A company that wants to reduce its WACC may look into cheaper source of finance. For example, it can issue more bonds rather than stocks as it will be a more affordable option. This will cause an increase in the debt to equity ratio as debt is cheaper than equity and ultimately the WACC will decrease.

Companies need to know their WACC because they need to identify which costs to reduce and analyze new investment projects. The WACC also provides a good way to explain the capital structure of a company and identify a good proportion between various kinds of financing sources. The lower the WACC, the better it is for a business to make further investment decisions.

Reference:

www.investopedia.com

www.corporatefinanceinstitute.com

Dividend Valuation Models

When an investor pays for buying common stock, he expects to receive future cash flows in the form of dividends. When the stock is sold, investor expects to receive the value of stock. It is difficult to determine the value of common stock because the future cash flows generated by dividends are not fixed. To determine the overall value of a stock dividend valuation models are used. The benefit of dividend valuation models is dividends are used to value the company and this is not total value because debt is not included. Different dividend valuation models are described below:

The Basic Valuation Model

The basic valuation is that in a rational market stock value is the present value of all future cash flows that the investor expects to receive. The time value of money principle can determine the present value of a stock based on the discounted value of future cash flows. Shareholders pay for the current share price and acquire the shares with the expectation of future dividends. The formula for dividend valuation model is:

P0 = D0(1+g)/(re-g)

Where:

P0 = The current ex dividend share price

D0 = The dividend that has just been paid or will be paid

re = The required rate of return

g = The dividend growth rate

The required rate of return indicates the time value of money for the uncertainty of the future cash flows of the investment. Where there is greater uncertainty, the greater required rate of return is required. When dividends grow at a constant rate the value of stock is the present value of a growing cash flow.

The Gordon Growth Model

The Gordon Growth Model assesses the reason of dividend growth. If all earnings of a company are distributed as dividend the company will not have additional capital to invest. The Gordon Growth model formula is given below:

G = bR

b = The proportion of earnings retained

R = The rate that profits are earned on new investments

Modigliani and Miller’s dividend irrelevancy theory

According to this theory dividend patterns have no effect on share price. If a dividend is reduced now the extra retained earnings will allow future earnings and dividends to grow. The equilibrium will reach when the retained amounts will be reinvested at the cost of equity. If a company retains earnings and uses it for reinvestment the share prices may not be affected. The company can use the retained earnings to produce higher returns and then dividends should be reduced to increase shareholder value. But when the company will use the retained earnings to produce lower returns then dividends will need to be increased to avoid the falling of share price.

Zero Growth Dividend Valuation Model

This model is used when a company’s dividend payments are expected to remain constant. The formula is:

P0 = D/ke

The model can be used to estimate the value of a stock for which dividend payments are expected to remain constant for a long period in the future.

Constant Growth Dividend Valuation Model

This model is used when a company’s dividend payments are expected to grow at a constant rate for a long period. The formula is:

Dt = D0(1+g) ^t

The model assumes that a company’s earnings, stock price and dividends are expected to grow at a constant rate.

Practical Considerations

There are many theoretical models for dividend valuation, but the practical considerations also matter. The announcement of dividend is a publicly available information and in a semi-strong form of efficient market the share price will react to this information. There is information asymmetry that is not in the public domain and shareholders will be unsettled by abrupt changes in dividend policy. If investors do not share director’s optimism about the company’s future success, share price will be affected. Another thing is that tax can affect investment decisions. When a company suddenly changes its dividend policy, it will disturb investor’s portfolio and investors have to adjust their mixed portfolio. Company liquidity is an issue as companies have to ensure that their position is sound, and they may have dividend reductions if they have to stay solvent. Sometimes dividends are reduced by lenders who put clauses in the loan agreement. Because if less cash is paid liquidity may be better. Sometimes, there may be some legal constraints for paying dividends.

It can be stated at the end that dividend model is useful when valuing a company that pays dividend. The basic principle behind the valuation model is that the value of a stock today is the present value of future dividends.

Reference:

www.investopedia.com

www.accaglobal.com