Corporate Actions: Understanding Their Impact on Stock Prices

When a publicly traded company announces a corporate action, it can significantly affect its stock price. Investors, especially shareholders or those considering investing, should grasp how these actions might influence the company’s stock performance. Corporate actions often serve as a signal of a company’s financial health and its prospects.

Key Takeaways:

• A corporate action refers to any event that brings material changes to a company and impacts its shareholders.
• Corporate actions typically need approval from the company’s board of directors.
• There are two types of corporate actions: voluntary, in which investors choose to participate, and mandatory, in which participation is obligatory.
• Corporate actions include stock splits, dividend distributions, mergers and acquisitions, rights issues, Contingent Value Rights (CVRs), spinoffs, name or symbol changes, and liquidation.

What is a Corporate Action?

A corporate action is any event undertaken by a company that materially affects its stakeholders, such as shareholders, bondholders, and even employees. These actions can alter the company’s stock price, governance structure, or financial health. Corporate actions often require approval from the board of directors and sometimes from shareholders.

Corporate Action Examples

Stock Split

A stock split occurs when a company divides its existing shares into multiple new ones, reducing each share’s price while maintaining the overall market capitalization. The most common form is a 2-for-1 stock split. For example, if you hold one share valued at $100, after a 2-for-1 split, you’ll have two shares, each worth $50.

While the split doesn’t change the company’s overall value, it has short-term and long-term effects:

• Short-term effects: Current shareholders may feel rewarded because they now hold more shares, and the lower share price might also attract new investors.
• Long-term effects: Stock splits often increase stock prices over time, signaling company growth. However, some investors worry that multiple splits could dilute the value of their shares.

The formula for Stock Split:

If the stock split ratio is S, the new stock price can be calculated as:

New Price = Old Price / S

Reverse Stock Split

In contrast to a stock split, a reverse stock split consolidates shares, reducing the number of shares outstanding while increasing the share price. For instance, a 10-for-1 reverse split would mean an investor holding ten shares at $1 each will own one share worth $10.

Reverse stock splits are typically used by companies whose stock prices have fallen significantly. The reasons for a reverse stock split include:

• Avoiding the negative connotations of being a “penny stock.”
• Attracting institutional investors who may be wary of lower-priced stocks.

Dividends

Companies can pay dividends in cash or the form of additional shares (stock dividends).

• Cash dividends: These are a distribution of a company’s profits to its shareholders. For example, if you own 100 shares and the company declares a $0.50 per share dividend, you will receive $50.
• Stock dividends: In this case, shareholders receive additional shares instead of cash. If the dividend rate is 10%, you would receive one extra share for every ten shares owned.

Cash dividends typically signal financial strength, while stock dividends increase the total number of outstanding shares, potentially diluting the value of each share. Companies that pay regular dividends may be seen as stable. Still, if a high-growth company starts issuing dividends, it might suggest that its growth is slowing.

Rights Issues

A rights issue allows existing shareholders to buy additional shares at a discounted price before they are made available to the public. Rights issues are often a way for companies to raise capital.

Shareholders see a rights issue as a benefit because they get first dibs on new shares. However, it can also be viewed as a sign that the company may need financial support.

Mergers and Acquisitions

A merger occurs when two companies agree to combine into a single entity. This can happen for various strategic reasons, such as expanding market reach or consolidating in a shrinking industry.

On the other hand, an acquisition involves one company purchasing a controlling stake in another company. Acquisitions can either be friendly or hostile.

A reverse merger happens when a private company acquires a publicly traded company to go public without the hassle of an initial public offering (IPO).

For shareholders, mergers and acquisitions can be either positive or negative. They could signal growth and expansion, or they could mean that the company is struggling to survive and is absorbing competitors.

Contingent Value Rights (CVRs)

A Contingent Value Right (CVR) ensures that shareholders will be compensated if a specific event occurs within a given time frame. CVRs are commonly issued during mergers or acquisitions when the value of the target company is uncertain.

The compensation under a CVR could be in the form of cash or additional stock. The value of a CVR can be volatile, especially if it involves stock, as share prices fluctuate regularly.

Spinoff

A spinoff occurs when a company separates part of its operations into a new, independent company. The company may issue new shares to existing shareholders before opening up those shares to the public.

Spinoffs often indicate that the company is looking to refocus its strategy or divest from a non-core business area. For shareholders, spinoffs suggest the company is positioning itself for future growth.

Name/Symbol Change

Companies occasionally change their name or trading symbol as part of rebranding efforts, often to reflect a shift in business strategy or to distance themselves from past controversies.

Name changes often occur after mergers, like when Bell Atlantic became Verizon Communications. Another example is when Apple Computer, Inc. became simply Apple, signaling its diversification beyond computers. A name or symbol change could also be a strategic move to improve public perception or align with new market realities.

Liquidation

In the worst-case scenario, a company may be forced into liquidation, meaning its assets are sold off to pay creditors. Ordinary shareholders are last in line to receive compensation when this happens, and they are unlikely to recover much from the sale of assets.

Liquidation signifies the end of the road for a company and usually results in the shares becoming worthless.

How Corporate Actions Impact Your Taxes

Corporate actions have different tax implications:

• Dividends: Cash dividends are typically taxed as income.
• Mergers and Acquisitions: If you receive shares from the acquiring company, you may be subject to capital gains tax.

Consult a tax professional to understand the tax consequences of various corporate actions fully.

Can Shareholders Oppose a Corporate Action?

In some instances, shareholders can oppose a corporate action, such as a merger or acquisition, by voting against it. However, the ability to oppose actions depends on the type of shares you hold (common or preferred) and the company’s governance structure.

Corporate Actions: Retail vs. Institutional Investors

Both retail and institutional investors are affected by corporate actions, but the scale of the impact often differs. With their extensive holdings, institutional investors may have more influence in decisions like mergers. Retail investors, however, may see their holdings diluted during events like rights issues. Additionally, institutional investors typically have faster access to detailed information, allowing them to react sooner.

The Bottom Line

Corporate actions can profoundly impact a company’s stock price and overall future. While some, like dividend payments or stock splits, are viewed positively, others, such as liquidation or rights issues, may cause concern among investors. It’s essential to monitor corporate actions closely and consider their potential implications for your investments.