Ideally a capital raising should deliver the classic ‘win-win’ by shoring-up capital reserves and paying down company debt while offering shareholders more shares at attractive discounts to traded prices. Unfortunately the benefits of capital raisings can be extremely one sided. That’s why it’s important to understand that all capital raisings were not created equally, and can be invariably value destroying for shareholders.
By learning how to identify an unfair capital raising, you (the shareholder) can avoid being diddled out of more cash and potentially a dilution in your shareholder value.
It’s not uncommon for a share price to rally following a capital raising – typically due to a quick mop-up of any perceived overhang in the market – and when it does shareholders are happy with their immediate windfall. But long-term wealth generation is a different matter, and it can sometimes take years to identify whether attempts to repair the balance sheet did add value.
A capital raising may indeed reduce company debt, but if it doesn’t result in increased earnings, the long-term value to shareholders is questionable. While a capital raising may dilute earnings per share (EPS) in the hope that the future earnings impact will be positive, this outcome is never guaranteed.
So if a capital raising has resulted in a material decline in intrinsic value, then sustainable price increases look less bankable. That’s because in the long run a company’s share price and its intrinsic value are destined to converge at some future point.
It’s not uncommon for the share price to gravitate towards (lower) valuations following a capital raising. When equity increases and the company doesn’t manage to raise profits by a proportionate amount, return on equity plummets. Just look at Wesfarmers (WES) in 2008, Newcrest Mining (NCM) since 2011 and BlueScope Steel (BSL) in 2009.
In 2008 Wesfarmers added $15,941.00 million in equity to its business. That year return on equity fell to 12%, from 25% the previous year. By December 2008, the year of the capital raising, WES’s share price had fallen to a low of around $14.50. It traded around $35.00 between 2004 and early 2008.
Capital History Evaluate screen shows WES’s 2008 capital raising
Newcrest added more than $2,000.00 million in 2008, and another $10,000.00 million in 2011. Each time capital was raised, return on equity fell. Between 2007 and 2008 ROE halved, from 12% to just over 6%.; In 2011 ROE was 9.2% compared to 124% in 2010.
Capital History Evaluate screen shows NVM’s 2008 and 2011 capital raisings
As a savvy investor, you need to ask yourself how any company could be so desperate for capital that it’s prepared to dilute existing shareholders so unashamedly?
While there are many types of capital raisings, one of the cleanest and most popular is where you (the shareholder) are offered shares at a fixed price or rights issues (aka a renounceable entitlement offer which unlike non-renounceable offers) can be sold on market (under the code ‘ASXR’) based on a pro-rata of the shares you already owned.
What makes a renounceable entitlement offer of value to you (the shareholder) is the difference between the ordinary share price and the offer price.
As a case in point, the Australian Securities Exchange (ASX) is currently raising $553 million by offering two shares for every 19 they hold, at a price of $30 each (a 16% discount to the price before the announcement). While this is expected to dilute earnings per share (EPS) by more than 5%, ASX management expects it to result in a positive earnings upside in the next financial year.
You’re not obliged to take up your renounceable entitlement offer, but remember loss of value is a by-product of issuing shares at a price discount. So by not participating, you’ll fail to offset the (shareholder) ‘dilution factor’ – a by-product of capital raisings that involve issuing more shares – unless the company has made other arrangements. To its credit, the ASX has provided for eligible retail investors who did not participate in the raising through $3.40 for each new share they did not take up and which was sold into the bookbuild process.
Beyond renounceable entitlements, the next most common capital raising is via a share purchase plan (SPP), which unlike (renounceable entitlements) are not required to issue prospectuses. An SPP is an offer (at a discount) limited to a maximum $15,000 worth of shares per shareholder in a 12-month period.
While this fixed dollar amount is great for smaller shareholders, it disadvantages those with considerably larger shareholdings. However, if demand is high – as is often the case on popular SPPs – shareholders won’t receive anywhere near their $15,000 worth of shares due to severe scaling back.
A third, and considerably less transparent capital raising option is via what’s called a placement, whereby large shareholders (typically institutions) get to buy shares at a discount. However, if smaller shareholders are not given the right to participate in a SPP alongside a placement then the value of their holding is diluted.
At face value, a rights issue can create opportunity to mitigate any dilution, assuming market capitalisation doesn’t change. But the trouble with speculating on this outcome is that it runs counter to what happens in most instances. It’s equally important to remember that if your goal is to capitalise on the spread between issue price and traded price, you’ve fallen from investor to speculator – and winning at this game requires fast footwork.
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