In the latest instalment in our first-time investor series, we look at the various ways in which companies raise money to fuel their expansion, then explore the reasons that companies undertake ‘share splits’ and ‘consolidations’.

PLACING NEW SHARES

The different methods by which publicly-traded companies raise money to fund expansion include the use of bank debt or the sale of new shares.

The three main ways in which companies can raise capital on the financial markets are share placings, open offers or rights issues.

A placing is the issue of new shares, either to existing or new shareholders. This dilutes the value of existing shareholdings as effectively it creates more slices of the same-sized pie.

When a company approaches potential investors for a placing, it can’t set a price above the current market price, because buyers would simply purchase the shares on the open market rather than participating in the placing. So in order to entice buyers, companies typically offer to sell their placing shares at a discount to the current market price.

Because buyers and sellers on the open market are aware of the secondary offering, the price they are willing to pay for the shares usually falls in line with the amount of the discount.

The long-term effect of a placing on the share price is much less certain. It depends on how effectively the management team allocates the additional capital raised.

Shares in budget airline Ryanair (RYA) climbed after it confirmed in September 2020 it had raised €400 million in a placing to help fund its growth.

The new shares were issued to institutional investors at €11.35 each, with the funding helping to strengthen its balance sheet and take advantage of ‘significant growth opportunities’ as rivals ‘shrink, fail or are acquired by government bailed out carriers’.

Another issue with placings is often they are only offered to institutions, disadvantaging those ordinary investors who can’t participate.

FIGHT FOR YOUR RIGHTS

A slightly more democratic way companies raise funds for large acquisitions, or to shore up stretched balance sheets, is through a ‘rights issue’.

This is an exercise that involves shareholders making the decision whether or not to buy discounted shares in the business.

An open offer is similar to a rights issue, except for the fact that the right is not tradeable and there is no sale of rights. Open offers are often combined with a placings.

Your options with a rights issue

Shareholders must take one of four routes. They can either buy some or all of their allocated stock; or they can sell all their rights. The rights associated with shares in a rights issue can be traded in the market and have an intrinsic value. These are known as nil-paid shares or nil-paid rights.

Shareholders are able to sell their rights to someone else and receive some money, all without having to sell their existing shares. They can sell some of their rights and potentially use the proceeds to buy some of the cut-price shares – this known as ‘tail swallowing’ – or do nothing at all.

DOING THE SPLITS

A share split is a corporate action in which a company divides its existing shares into multiple shares. Companies choose to split their shares to boost liquidity, as the exercise reduces the trading price of each share to a range deemed comfortable by most investors, although the effect is purely psychological as the value of an investor’s holding is unchanged by the process.

When a company announces a ‘share split’, this means that the number of shares in that company increases, so the price of each share goes down, though the market capitalisation remains the same.

The most compelling argument for splits is that they can make it easier for retail investors with limited resources to access the stock directly, as each share is less expensive after the split.

In August 2020 Tesla effected a five-for-one stock split after an amazing share price run. This was the first time Tesla had split its stock and meant that investors received an additional four shares for each one they already owned.

Apple split its stock on a four-for-one basis effective 31 August, marking the fifth occasion the technology giant has split its stock since going public back in 1980, with the company echoing Tesla’s argument that a split would make its high-flying
shares more accessible to individual investors.

The opposite of a share split is a share consolidation, also known as a ‘reverse split’, where a company decreases the number of shares in issue, causing the share price to increase proportionally. Consolidations normally occur after a share price has cratered and are often an attempt to restore a bit of credibility given the stigma associated with being a penny stock.

As with share splits, the important point to note is there is no impact for the individual shareholder as the value of each holding remains the same.

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