Effects of Corporate actions on Stock prices: Part I

Today, let me cover some details about the corporate actions that affect the stock prices drastically. It is an important aspect of stock trading and should be given thorough consideration.

What are Corporate actions, or commonly known as CA?

Any decision by the corporate, or a publicly listed company, that changes its valuation structure in terms of stock structure is known as corporate action. Let me explain this with an example:

Suppose a company decides to list itself on stock exchange by offering a portion of its shares to public through an IPO. Suppose, the company is divided into 100 million parts called shares. Each share is sold at 20 $ each. Of the 100 million shares, the promoter or the actual owner decides to keep 80 million shares with him and sell remaining 20 million to the public at the rate of 20 $ a share. So, when the IPO is fully subscribed, it will give him 80% ownership in the company (with 80 million shares) and 20 $ * 20 million shares = 400 million dollars of capital money, which he can utilize.

Hence, a structure is formed for the company, after it is listed on the stock exchange. In this structure, the company has a total of 100 million shares (including that of the promoter). The total value of the company will be calculated as follows:

Total value or Market Capitalization = Total no. of shares * Price of each share

Since the price of shares keep changing everyday and every minute, the market cap or market value of the company keeps on changing accordingly. However, the structure of the company remains the same, atleast in terms of no. of shares, which remain the same at 100 million.

Any news item or action that is directly dependent upon or affects the no. of total shares, is considered as corporate action.

The simplest example of a corporate action is dividend payment. Suppose a company declares a dividend of 2$ a share. Hence, since it has a total of 100 million shares, it will have to payout a total of 200 million $ as dividend. Since this news item or action is directly dependent upon the no. of shares, it constitutes a Corporate Action.

Another example: Stock Split
Let’s say the stock price of the above mentioned company has increased drastically. It started with 20 $ a share and reached 2000$ a share in 5 years time. Though it a good news for the investors, it may sometimes become a problem for the company.
The problem comes in the form of lack of liquidity– which means due to high stock prices, it may not be possible for people to easily buy and sell shares, as they will need big amounts of money to buy and sell shares. Obviously, people will find it more convenient to buy a 20$ share than buying a 2000 $ share. It becomes more important for retail investors like you and me, to have liquidity in the market in terms of lower stock prices. If I have only 500$ to invest, I can buy 25 shares of a company trading at 20$. But I cannot buy a quarter of a share of a stock trading at 2000$.

So, from the point of view of company, when the stock price rises drastically, it becomes important for it to make it affordable to the common man, so that trading can continue smoothly. A simple way to do it is to go for a stock split. Here is how it works.

Total no. of shares: 100 million
Price of each share: 2000 $
Total Value of the company: Shares * Price = 100 million * 2000 $ = 200,000 million $

The company decides to go for a stock split in the ratio 1:10. This means that the each existing share of the company will be split into 10 shares. So the total no. of shares will become 10 times. However, since the total value or the market value of the company is not supposed to change, the price will get adjusted by a factor of 1/10.
After stock split:

Total no. of shares: 1000 million
Total Value of the company = same as that before stock split = 200,000 million $.
So price of each share = 200,000/1000 = 200 $ each.

Hence, the initial price of 2000 $ is now changes to 200 $ and the owners of the shares have 10 times more no. of shares than they had before the stock split.

The first example of dividend payout was a type of corporate action that directly depended upon the no. of shares. The second example of stock split was a type of CA that changed or affected the total no. of shares. Hence, they constitute the corporate actions, as they affect the company details at the corporate level.

Continue to Part II of this article