Corporate Actions: A Beginner's Guide
Updated: Feb 5, 2022
Investing in the stocks and shares is often seen as complex and scary. It’s hardly surprising. After all, we have all heard horror stories about investors who didn't understand what they were doing, or were bamboozled by a financial 'expert'.
But yet all investors dream that we will find the next Facebook or Tesla, and make our fortune through investing in the stock market.
Now, of course, nobody can guarantee you will make your fortune, but there are a number of ways you can give yourself a better chance of investing successfully, whilst at the same time protecting your future.
The best way to do those things is to educate yourself about the mechanics of the stock market and how companies go from private to public, and the stock markets events that characterise the day-to-day adventures of investing in the stock market.
But first, let’s start by outlining a few golden rules for investing in stocks and shares:
Know what you want to achieve
A lot of people make the mistake of diving in head first without having a vision of what they want to achieve. Ask yourself, why are you investing? How much money do you want to make? What are your long-term goals? How much do you need to make to secure your future?
Everyone’s investment journey is different, and you need to be clear about what you are hoping to gain from your investment in stocks and shares.
Understand what type of investor you are
Another important step you need to take when investing in stocks and shares is determining what type of investor you are. What is your investment style? You need to work this out before you begin so you can make sure you go down the right path.
This includes analysing your attitude to risk, as well as determining whether you prefer old-fashioned fundamental analysis or whether you are technically orientated, and so analysing charts would be better suited to you.
Differentiate between big and small companies
There are pros and cons associated with investing in both large cap and micro cap stocks. You need to understand the difference so you can determine the best route for you.
Investing in Apple stock may seem tempting because it is a big brand, and so you assume it’s going to be performing well. However, this does not always translate into the best investment opportunity. The big 'blue-chip' names that are listed on the FTSE 100 or the Dow Jones appear to be reliable and steady, however, this often means that there is limited potential for them to surprise on the upside. On the other hand, smaller companies can fly under the radar, which means you could end up with higher returns if you pick a winner. Nonetheless, this does also mean that they are a lot riskier, so it is all about working out what is right for you.
Manage your risks
Last but not least, risk management is a must for any person that invests in stocks and shares. Putting all of your cash into one business can be an extremely bad decision, but it can also be a very good decision. It's all about understanding your own risk appetite and how each investment contributes towards your overall strategy.
So what about the daily 'events' that impact the valuation of stocks listed on the various stock exchanges across the globe?
Let's demystify some of the regular stock market events, known as corporate actions, which may impact listed companies you decide to invest in:
A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a proportion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-invested in the business, known as retained earnings.The current year's profit as well as the retained earnings of previous years are available for distribution as dividends, at the discretion of the company's Board of Directors.
Dividend distribution to shareholders may be in cash (usually a deposit directly into your stockbroker account) or, if the company has a dividend reinvestment plan, the amount can be paid by the issue of further shares, or by share repurchase.
Therefore if you buy shares in a listed company which decides to offer a dividend to its shareholders, you will be paid a dividend amount relative to the number of shares you hold.
A dividend is distributed to a certain class of the shareholders, so it is important that you understand what type of share you are buying. Common or 'ordinary' shareholders of dividend-paying listed companies are usually eligible, as long as the stock was owned before the ex-dividend date.
Stock Splits and Reverse Stock Splits
Unsurprisingly a reverse stock split operates in just the same way as a normal stock split does, only in reverse. But what are they, and how do they impact the price of a listed stock?
A stock split, sometimes referred to as a 'stock divide', is a decision taken by the listed company to increase the number of shares in a company. Therefore a stock split is designed to cause a decrease in the market price of individual shares, but crucially does not cause a change of total market capitalisation of the listed company. Stock dilution does not occur from a stock split and, all other things being equal, following a stock split you will have more shares in the listed company, but the total value of your shareholder before and after a stock split will be the same. Ratios of 2-for-1, 3-for-1, and 3-for-2 splits are the most common ratios used in stock splits, but any ratio is possible. Investors will sometimes receive cash payments in lieu of fractional shares, following a stock split.
A reverse stock split, as you may have guessed, is a decision taken by a listed company to decreased the number of shares in circulation and therefore results in a reduction in the number of shares you hold. However, again crucially, the share price will be proportionally greater than it was prior to the reverse stock split, meaning the company’s market value will not be altered, and all things being equal, neither will the total value of your investment.
This term is used to describe a group of rights, which are provided to current shareholders for the purpose of purchasing extra shares in a listed company. The aim of a rights issue to is raise capital for the listed company which has issued them. The number of rights received as part of a rights issue by existing shareholders is proportional to their existing shareholding.
These 'rights' are deemed to be a kind of option, because the existing shareholders have the right, but not the obligation to buy extra shares in the company at a given price, which is usually at a discount to the current market price and is equal for all those taking part in the rights issue.
Although rights issues do not have a direct impact on the market price of the remaining outstanding shares, the offer of rights at a discounted price often has a psychological impact on the broader market, leading to the market price falling to correlate with the discounted offer price of the rights. The net outcome of a rights issue is that more shares are allotted to the market.
A share buyback occurs when a listed company decides to purchase its own outstanding shares, in order to lower the number of shares in circulation on the open market. You may also see this referred to as a share repurchase.
Listed companies may buy back shares for a variety of reasons. For example, it could be to stop other shareholders from taking a controlling stake in the company, or to boost the value of the remaining shares available by lowering the supply.
Mergers and Acquisitions
Often shortened to M&A, mergers and acquisitions is a general term that is used to describe the consolidation of assets or entire companies, which the resulting corporate entity being a combination of the previously separate companies.
Mergers can be structured in various ways, based on the relationship between the two companies that are involved in the deal. However, for shareholders of listed companies undergoing a merger, it is important to understand the potential impact that the merger may have to the value of your shareholding.
In the case of cash mergers, the acquiring listed company agrees to pay a certain amount for each share of the target company's stock. The target company's share price would therefore likely rise to reflect the takeover offer. Therefore if you hold shares in a takeover target, it is likely to result in an increase to the value of your shareholding. If you continue to hold those shares you will then receive the value per share offered as part of the takeover.
After a merger officially takes effect, the market price of the newly-formed corporate entity usually exceeds the value of each underlying company during its pre-merger stage. In the absence of unfavourable economic conditions, shareholders of the merged company usually experience positive long-term share price performance and increased dividends.
Last but not least, a spin-off is when a listed company generates a new independent company (which may also be listed on a stock exchange) by distributing or selling new shares in the business to be spun-off. Existing shareholders are likely to be offered the opportunity to purchase shares in the newly spun-off entity, or may be granted shares automatically based on their existing shareholding.
A spin-off is a sort of divestiture. A business will create the spin-off expecting that it is going to end up being worth more than when it was part of the larger company. You may also see a spin-off referred to as a 'starburst' or a 'spin-out'.
So there you have it.
Everything you need to know about stocks and the various corporate actions that can impact their value.