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Rewriting History: Splits, Consolidations & Rights Issues

Sunday, Dec 30 2012 by
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Rewriting History Splits Consolidations  Rights Issues

As part of our research when assessing prospective share purchases it is important to look at trends in certain key figures and ratios across a number of years. In particular, dividend investors are usually keen to see a history of increasing dividends per share over several years as this gives some confidence not only that the company has been performing well, but also that dividends are viewed by the directors as an important part of their shareholders’ return.

Although the continuing payment of dividends is not a legal obligation – in fact it is totally at the discretion of the directors – it is often considered to be a “moral” commitment by the company to at least maintain, and preferably grow the annual payout. To cut the dividend is not only frowned upon by shareholders, but it is an admission of poor performance by the company or concern about its near term prospects or financial health. It is also often thought that such a moral commitment grows deeper within the company’s culture the longer the period over which the company has continued to grow or maintain its dividend, as well as being prima facie evidence that a company can weather different macro environments and business cycles.

So we might often hear reference to so-called “dividend heroes” which have continuously maintained or raised their dividend payouts over many years. For us to establish dividend growth and earnings growth histories we need to look at the company’s archive of annual reports, although when we do so we need to exercise great care over any historical per share figures. When there have been changes to the issued share capital of a company which had no impact upon its financial resources, then certain adjustments to such historical figures may be required. Very often investors will misquote the financial history of a company if they fail to pick up on such adjustments and therefore this is an important point to bear in mind when carrying out research.

The changes in share capital to look out for are as follows:

  • Share splits
  • Share consolidations
  • Bonus issues
  • Bonus element of other issues such as rights issues

Share splits

Occasionally, after a company has enjoyed many years of profit growth and its shares rise very strongly, each of its shares could become worth tens, hundreds or even thousands of pounds. As a result the company may decide that it wants to improve liquidity in the shares by increasing the number of shares in circulation with a corresponding reduction in the value of each share. So for example if each share is priced at £50 then the company could could split each share into ten so that each new share would then in theory be priced at £5. Clearly, there is no overall change in value.

An example of a share split is when Chemring (LSE: CHG) announced a 5 for 1 split in 2011. When I carried out some research on the company for a recent article I had to ensure that all of the historical earnings per share and dividends per share figures prior to the split were therefore divided by 5 for comparability.

Share consolidations

A share consolidation, sometimes referred to as a “reverse share split”, is occasionally seen when the opposite happens i.e. a share falls dramatically in price and becomes worth only pennies. The company may try to reduce volatility in the share price by, for example, replacing ten shares with only one, thereby inflating the price of each new share by ten times.

An example of this was seen with Royal Bank Of Scotland (RBS) in 2012. After the banking crisis when the company’s shares fell to less than 20p, RBS announced a ’1 for 10′ share consolidation. Readers may remember seeing the RBS share price increase ten fold on the day the consolidation took effect – hopefully without getting too excited!

Bonus issues

A bonus issue, sometimes also referred to as a “scrip issue” or “capitalisation issue” has the same practical effect as a share split in that it increases the number of shares in circulation without calling upon the shareholders for additional monies, thereby again reducing the value of each share accordingly. The only difference between the two is how they are treated for accounting and legal purposes: a bonus issue creates new shares by reducing the amount of the profit and loss reserve i.e. it is just re-allocating the existing shareholder equity from one pocket to the other.

Rights issues

Rights issues are the more complicated one and result in a less obvious adjustment, therefore I will go into more detail below.

Rights issues are a method by which companies can raise additional capital through the issue of new shares, for example if it needs to raise funds for growth or acquiring another company, or to repay borrowings to strengthen its balance sheet – the latter being fairly common in recent years. They are different to share placements in that they preserve the “pre-emption rights” of all shareholders i.e. the existing shareholders are given the option to subscribe for the new shares proportionately to their holdings, thereby maintaining their percentage share of the company.

As stated above however, the only type of share adjustment we need to worry about is those which do not result in a change in the company’s financial resources. Although rights issues do require shareholders to pay out for their new shares, the “problem” arises in the fact that the cost of subscribing for the new shares is at a discount to the current market price which is done in order to make the issue appear more attractive.

As a result of this discount, a rights issue is, in effect, equivalent to a combination of shares paid for at the market price and shares received for free. The latter element is therefore similar to a bonus issue and so it is usually referred to as “the bonus element of the rights issue“. The trick then is to try to calculate the correct adjustment factor in order to make our adjustments to the per share histories as we do with splits and consolidations.

As with splits, this adjustment will result in a reduction in our earnings per share and dividends per share histories, although usually it is far more subtle a change, often in the range of a 10-25% reduction. But if we don’t take this adjustment factor into account it may appear to us that there has been a small drop in earnings or dividends; and the apparent “dividend cut” might put prospective investors off a company which actually has a record of dividend increases.

The adjustment factor for the bonus element of a rights issue is calculated as follows:

share price prior to going ex-rights ÷ theoretical ex-rights price per share

Where “ex rights” refers to when the shares lose their right to subscribe to the rights issue (in the same way we refer to the “ex dividend” date for when a share loses the right to a dividend).

If that’s about as clear as mud, don’t worry, we will have a look at a worked example below.

Rights issue worked example: Imperial Tobacco

The following table shows the dividend history of Imperial Tobacco (LSE: IMT) from 2000-2012, both before and after taking into account adjustments due to rights issues:

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During the period shown IMT had two rights issues, one in 2002 and one in 2008. Circled in red we can see the effect of these on the actual dividend payouts in those years due to the increased numbers of shares in issue: in 2002 a very small increase; and in 2008 a reduction, both of which are in contrast to the double digit increases in almost every other year. The adjusted figures however show a record of continuous growth and an increase in the 12 year compounded annual growth rate from 10.5% to 13.6%.

If we take the figures for 2007, the year before the last rights issue, the adjustment factor is a reduction of approximately 1.15. Let’s see if we can work out how to arrive at this number.

Firstly we need to start with the details of the rights issue by looking at IMT’s rights issue announcement here. This gives us the following details:

  • 1 new share is to be issued for every 2 existing shares (a ’1 for 2′ rights issue);
  • the subscription price of each new share is 1,475p;
  • the last day before the shares go ex-rights is 20th May 2008; and
  • the new shares will trade without the right to the interim dividend of 24p.

So we now need to work out the figures in the equation given above:

share price prior to going ex-rights ÷ theoretical ex-rights price per share

The share price prior to going ex-rights can be found by looking up the historical price on 20th May 2008 which was 2,455p. Note that this was significantly higher than the 1,475p subscription price for the rights issue. Given that the new shares were to trade without the right to the interim dividend we must also deduct 24 pence to get to the ex-dividend price, giving us our numerator of 2,431p.

Now for the denominator: the theoretical ex-rights price. This is calculated by taking the weighted average price of the existing shares (calculated above) and the new shares taking into account the price payable for the latter of 1,475p. So we get:

Theoretical ex-rights price per share = {(2 x 2,431p) + (1 x 1,475p)}  ÷ 3 = 2,112p

So, the adjustment factor for the bonus element of the rights issue is 2,431p ÷ 2,112p = 1.151. This means that any “per share” ratio, such as dividends per share or earnings per share, needs to be divided by 1.151 for each and every period or year looked at prior to the rights issue.

Nil paid rights

All the above is of course a bit theoretical and it can be hard to relate this ‘adjustment factor’ to real life, but there is another way to think about it. We have worked out that the price of the shares should trade ex rights for 2,112p. Given that we have the right to subscribe for shares for 1,475p, these rights have value and the shareholder can instead elect not to hand over any money and instead simply sell their ‘nil paid rights’. In this case they are worth the ex rights price of 2,112p less the subscription price of 1,475p, i.e. 637p.

So say we held 2,000 shares in IMT, we could just sell the 1,000 nil paid rights and pocket 637p x 1,000 = £6,370 instead of putting new money into the deal. We could invest this amount wherever we wanted to, but say we actually chose to buy further IMT shares with it, we could afford £6,370/2,112p = 301 shares. So simply assuming a cash neutral transaction (excluding costs for this purpose) we could end up with 2301 shares, or 1.15 times more than before i.e. our adjustment factor calculated above. We can therefore see that this is similar in effect to the share split.

(Note: a commonly used cash neutral transaction is to sell enough rights to take up the remainder of the rights. This is, rather amusingly, known as ‘swallowing your tail’).

Practical application for investors

I know what you’re thinking: “my gosh, I hope I don’t have to do that as it’s a real pain the a***”. And I agree with you there!

As it happens, with respect to the example given above, IMT’s investor relations department have been incredibly helpful as the dividend history on their website actually gives us the adjusted figures taking into account the 2002 and 2008 rights issues – see here.

Sometimes companies also present a 5 or 10 year review in their annual report which may make such adjustments. An example of this is RPC Group (LSE: RPC) whose 2012 accounts (pdf file) helpfully present a 10 year summary of figures (see page 106). Below the table they state:

Comparative figures for earnings per share and dividends per share have been restated after adjusting for the bonus element of the 5 for 8 rights issue in 2011.”

But not all companies are this helpful and it can be difficult to pick up on all of these share capital adjustments. The financial databases of the popular investing websites tend to be quite good at picking up the splits and consolidations, but I have found that rights issues are either not adjusted for, or the adjustments are sketchy and not applied consistently across the whole history. One tip here is to look at the number of shares in issue from year to year and see whether there has been a material increase or decrease. If so, look into it in more detail in the annual report to see whether it was as a result of any of the processes referred to above.

So that just leaves me to wish you all a Happy New Year. Don’t forget though, it doesn’t mean that prior years won’t need to be rewritten at some point in time!

Image courtesy of adamr / FreeDigitalPhotos.net


Filed Under: Stock Splits,

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I am the author of the Miserly Investor blog at http://miserlyinvestor.com and a keen private investor, having developed an interest in the stock market from a young age. By profession I am a Finance Director and a qualified Chartered Accountant and so my approach to investing is very much based on a business perspective with a focus on company fundamentals. The Miserly Investor blog concentrates on equities, in particular value and dividend investing strategies, usually with a long term buy and hold approach. more »


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