Share Buy back and Earning per share EPS-Part I

In my previous article, I had given An introduction to corporate actions, and how it affects the share price.

In this article, I’ll quote a live example of how companies use corporate actions or corporate restructuring to gain benefit and goof up the financial figures.

Really increasing revenue, sales and earnings is not the only way for corporate to show profitable figures. Smart kind of capital structuring can work wonders. Share buyback is one such excellent way of making a nice, healthy and profitable balance sheet, as illustrated in the following example:

When most of us talk about midcap or smallcap growth stocks, we talk about relatively young companies with new products or services that are growing at a fast rate, typically 20% to 25% per year or higher. This figure is available in the balance sheet and quarterly reports and is reported under the EPS or earnings per share.

This value of EPS, typically indicates how much income has each share made. EPS is widely followed in the industry, not only by researchers but also by individuals to track the performance of the company. How can this figure be manipulated?

Let’s discuss a case here: There is a company called Utah Medical products and is listed in NASDAQ. It is in the business of making Medical Instruments. For the past 5 years ending in year 2002, this company has been growing at a staggering rate of 20% per annum. The share price has increased from $7.5 to a high of 18.5$ which is more than 150% profit. How can a company continuously maintain such track record?

One way is to make real profits. Another way is to take advantages of corporate restructuring and corporate actions. Utah Medical Products used a combination of both – mainly of the latter.

The revenues of Utah MP did not grow much. From a high of $42 million in 1997 to $27 million in 2001, the revenues have actually come down. Yet, the earnings per share have increased from $0.5 to a high of $1.15, which is almost 125% increase in the period 1997-2001.

This high value of EPS was from smart Share Repurchase or share buyback plan. How does it work? In simple terms, a company invests money into projects and earns profit. This profit is a certain amount – may be in millions of dollars. This total amount of money is then divided by the total no. of shares, to calculate Earnings per Share or EPS. The reason why EPS becomes important and highly common factor for analysis is because it simply tells you how much each share of a company is earning. This gives a good parameter to judge companies and select between 2 shares. If you want to select between IBM or Microsoft shares, EPS can be a decisive factor.

Continue to Part II of this article

(2)-Share Buy back and Earning per share EPS-Part II

This is part II of the article Share Buy back and Earning per share EPS – Part I. Please start reading this article from the beginning, before proceeding with this part.

So suppose, there are 100 million shares of Utah MP, and are currently trading at 2$ each. So the total value of the company stands at 200 million $. Suppose the company generate an income or earning of 50 million $.

Hence, the EPS of the company becomes = Total Earnings/Total no. of shares

= 50 million/100 million = $ 0.5

Now the company decided to buyback 10 million shares from the investors, at the market price of 2$. So, the investors will be paid a total of 20 million $ and the company will receive 10 million shares from the investors. Hence, the remaining no. of shares will be used to calculate EPS on the same total earnings:

Hence, the EPS of the company becomes = Total Earnings/Total no. of shares

= 50 million/90 million = $ 0.55

This is a clear-cut increase of more than 11% in EPS. Therefore, without actually generating extra earnings or income, the company can still show profitability and increase in EPS year-on-year.

Experienced researchers and equity research teams while looking at EPS also take these factors into consideration, like share buyback or corporate actions. However, we common investors fall victims to such things. If you look for EPS on Google, you will find most of the financial sites mentioning that we should look at past records of continuous growth in EPS year on year. What we fail to realize is how to take into consideration the effects of share buyback and other corporate actions, which are used as effective tools by the companies to make a fool of investors by presenting bloated figures.

Here is the exact data for Utah MP and how it worked:

Year	2001	2000	1999	1998	1997
Shares Outstanding	5210	5978	7197	8273	8495
EPS ($)	1.15	0.9	0.76	0.6	0.5

Over the 5 year period, the company continuously kept on buying back the shares and hence ended up showing a 125% rise in EPS, from 0.5 to 1.15$. Though there was some real growth and a continuous decline in revenue, majority of these figures were bloated because of such schemes of buyback.

As we can observe from the above example, EPS figure may appear to be pretty interesting and effective tool to make a comparison for stock picking or stock selection. However, care should be taken while observing the historical data. One should keep in mind that there may be a big possibility of a corporate action or corporate restructuring, which will result in high values of EPS. As demonstrated above, Utah MP bought back the shares continuously for 5 year period, resulting in a fantastic growth in EPS year on year. People in the accounts department of the company are experts in such tricks. Researchers who are educated know how to adjust the calculations. Individual investors like you and me get trapped with these jazzy numbers. In fact, any data presented on balance sheet or financial results should be looked upon with a doubt, as one figure is derived from the other.

Keep visiting this blog for further content.

Please read the comments and post your views and queries in the comments section which helps in open discussion and avoid duplicity of questions.

You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.

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

(2) Effects of Corporate actions on Stock prices: Part II

This is part II of the article Effects of Corporate actions on Stock prices . Please start reading this article from the beginning, before proceeding with this part.

There are several other types of corporate actions: Rights issue, spin-offs, mergers, acquisitions, share buy-back, etc.

An important question is: whether these corporate actions create any value for the company?

Theory says there is no benefit of CA; Practical cases refute the theory.

As per the theory, (Miller Modgiliani postulate), there is no value created by corporate actions or corporate restructuring. The reason is that the net value of the company remains the same. For e.g. as I’ve quoted in my previous article, about news based trading, Around 2-3 years back, Balaji Telefims (The Saas-Bahu serial TV Company led by Ekta Kapoor), was trading at Rs. 105. It declared a dividend of 16 Rs. a share. Within 1-1.5 minutes the price of the stock reached 121-122 Rs. I acted on this news an hour later and purchased the shares at 122 Rs. After the dividend expiry, the price fell back to 102-103 levels (later even to 85 Rs.). I got the dividend, but I got nothing better than the market price, instead I paid more than the market price after the ex-dividend date.

However, due to the dividend declaration, there was some price change in the market. So practically, there is some effect of corporate actions on the stock prices and valuations.

Lets take the case of a stock split. A colleague of mine acted on a stock split news of a penny stock: IQMS Software. The stock was trading at around 8 Rs. when the news of 1:10 stock split came in. Immediately, the price started to increase and touched a high of 13 Rs. My friend bought this stock in big numbers at 11 Rs. After the stock split, the price had changed by a factor of 10, i.e. his buy price of 11 Rs. was now Rs. 1.10 and the no. of stocks he bought was multiplied by 10 times. He invested a total of around 1.5 Lakh Rs. for purchasing this stock. However, after the split, the stock price started to decline, touched a low of 0.36 Rs. and as of today, it is 0.75 Rs. My friend is waiting since last 2 years just to recover his money. The stock has never made to his buy price of 1.1 Rs.

Even though the prices fell back to as low as 0.36, there were changes in the initial levels – from 8 Rs. to 13 Rs. People who managed to book profits were happy, those who couldn’t, are still waiting (like my colleague).

However, in practice, due to corporate restructuring actions, there is obviously some change. For the case of stock split, the change is in the form of more liquidity being induced in trading. Hence, the prices show an upward trend. Whether one can capitalize upon that change and how much he can gain, is still a question that leads to high level of uncertainty. The MARKETS ARE EFFICIENT –hence, everything is reflected immediately in the price. One may be lucky enough to get a piece of cake, just by chance. How long will that piece grow, no one knows. When it will start contracting, no one knows. Stock splits of companies like Reliance or Mahindra have proved to be positive in the near past, though there have been instances where rights issues of companies like Ballarpur Industries have failed and resulted in value decrease.

In practical essence, corporate actions do add some value to your holdings. The value may be positive or negative. It may be in terms of liquidity being induced, or due to a part capitalization of your holdings (like paying a dividend). Whether you want to act on any such news or keep away, is your choice.

This article was to introduce corporate actions and how it affects the market prices.
In the next article, I’ll give examples of how companies make a fool of investors by taking advantages of the corporate actions and improve their balance sheet figures. Please visit this blog tomorrow as well.

Keep visiting this blog for further content.

Please read the comments and post your views and queries in the comments section which helps in open discussion and avoid duplicity of questions.

You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.

Accounting/Auditing firm PWC in trouble for Global Trust Bank problems

It has been 3 years now since Global trust bank collapsed.

It was a Saturday in 2004, when the news came in about GTB bank being ordered to close down by the regulatory authorities. There was a widespread panic among the account holders of GTB bank. They were afraid about the money they had deposited in GTB bank accounts. Many private organizations had their employee’s salary accounts in GTB banks. All these people panicked. Moreover, since the news came in on Saturday, no one could do anything. ATMs were blocked, all bank branches closed. Account holders gathered at ATMs and branches with their debit cards and check-books, but no one was allowed to withdraw money from their accounts.

Banks are considered to be safest organizations – this assumption is very incorrect. The world of finance is full of examples where centuries old major banks have collapsed within a matter of days. Barings bank, GTB bank, just to name a few.

Situation was worse for the shareholders of GTB bank. Being a Saturday, there was no trading. Coming Monday, when the markets opened, there were only sellers and no buyers. The stock went down from 8 Rs a share to 2 Rs. and later to zero. The bank had collapsed completely and the stock investors were the ones who lost miserably. Though I was fortunate enough not to have any holdings of GTB stock in my portfolio, but I still cannot forget the look on the face of a colleague who had GTB stocks worth 30,000. That day, 30,000 of his holdings were translated to zero, or a 100% loss.

Later, Oriental bank of commerce acquired GTB. The bank account holder’s money was safe, but the people who lost dearly were the stockholders of GTB.

No equity research analyst, no fund manager, no auditor was able to predict the destiny that GTB stock had met. Instead, it was suppose to be an emerging star of the banking midcaps.

Why am I raising this issue of GTB today after 3 years? No, I’m not going to quote it as another straightforward example of risk in equities, but I want to highlight another debate that has recently begun.

Accounting firm Pricewater House Coopers or PWC was responsible for auditing the bank records of GTB. Banks have a class of assets or holdings, which may result in losses. This falls into the category of NPA or Non-performing assets. The higher the value of NPA for a bank, the worst is its performance. For example, NPA may be coming from the defaulted loans that bank has given to people who defaulted on payment on loans and bank has no way to recollect it back.

Pricewaterhouse coopers was doing auditing of the records of GTB bank and yesterday it came to light that PWC did not report the high level of NPA that GTB bank had. Instead, while doing accounting, it reported a very low level of NPA which was way below the actual figure. Now, the regulatory authorities are going to launch an investigation in which PWC practices have become questionable. PWC can face severe problems, which may include barring it from continuing accounting or auditing work in India for a period which may range from 3 months to 10 years.

The point that I’m trying to make is that it took 3 years for the regulatory authorities to just come up with the charges against the alleged malpractices and the firms and people involved. How long further it will take for the truth to come out, I guess even God cannot tell. Even after the truth is revealed, can the stockholders of GTB get anything – NO. All they can do is repent on their investment decision and think about maintaining caution for further investments. The truth is that the bank collapsed in just 1 day – though being advised as a midcap star performer just few days back.

No fund manager or researcher could guess the destiny of GTB bank. The reason, all their recommendations and investment decisions were based upon the balance sheet analysis, profit and loss account – which ultimately proofed to be erroneous. It’s all there in the past – what will be happening in the future no one can tell with confidence.

Trusting the balance sheets, profit and loss account, Earnings per share EPS, or similar such figures reported in the quarterly or annual financial results can be very risky. It’s easy to say that if there are any problems in the financial reports, the management and governing body members will be put behind bars. However, the truth is that it’s the investors like you and me who loose money. What would an investor get if the financial officer of a bankrupt company is sent to prison? The investor gets nothing – instead he looses his investment. By the time the reality is revealed, it’s too late.

Chasing midcap performers is easy, taking risk is also easy. Let’s just keep in mind the case of GTB bank – 3 years, yet to trace the culprits.

Keep visiting this blog for further content.

Please read the comments and post your views and queries in the comments section which helps in open discussion and avoid duplicity of questions.

You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.

Complex Insurance Policies to be taken off

Not sure how many of you have missed an important news item yesterday.

The IRDA or Insurance Regulatory Authority, which sets the standards and protocols for the insurance companies to operate and sell the insurance policies, has issued a notice to some insurance companies regarding their policies.

The notice is issued for taking off the policies from the markets which are very complex in nature, especially in terms of the way they charge commission. The problem identified by IRDA is with regard to the insurance policies having highly complex commission structure. “Better Late than Never” – atleast IRDA woke up to take some action against the freely flowing insurance markets, which appeared to be completely insane and out of control.

The two worst hit insurance companies are Allianz Bajaj (with its Super Agent) and Aviva (offering UNCERTAIN “Kal Par Control” – by deducting CERTAIN heavy charges today itself). These are the 2 companies which have highly complex commission charges structure for their insurance policies.

Readers are advised to go through the COMMENTS SECTION of my previous article Insurance v/s Investment v/s Tax savings – agent based business . There, Shashi had asked me about explaining the commission structure of the UnitGainPlus Single Premium Policy from Allianz. Here is how the policy was charging commission and administration fee to the investors:

You invest 2 Lakh in this policy. The policy mentions that 98% of your money will be invested while ONLY 2% will be the charges. This gives the impression that 98you’re your money will be invested. But the truth is that first, 98% of your money will be invested, so you would be given Policy Units worth 98% of your money. From these units, they will deduct further charges, by canceling the units from your account. Here is what the policy mentions:

-Policy Administration Charge: Rs 600 per annum deductible monthly through cancellation of units, inflating at the rate of 5% per annum.
What this means? Though your invested amount will be 98% of 2 Lakhs, they will recover the admin charges by first investing your 98%, and then immediately canceling some of the units equivalent to 600 Rs. per annum. Moreover, this charge will keep on increasing at 5%, meaning, each year the admin charge will keep growing at 5%. Another problem is that the charges are deducted each month. This means that the compounded value of your investment will suffer severely.

-Fund Management Charge: The fund management charge would be levied on NAV and the rate is as follows: Equity Growth Fund 1.75% p.a., Equity Index Fund II 1.25% p.a., Liquid Fund 0.95 % p.a., and Bond Fund 0.95% p.a.
Now what's the point in paying 1.75% charges each year in the name of fund management? All charges again deducted by canceling the Units.

This policy is doing nothing but making a fool of the investor (as other policies do too) by disguising the charges. First they say that 98% of the money is allocated and you get units worth 98%. Then they deduct their charges by cancelling the Units that too on a monthly basis. Smart People, Smart Way of Charging.

IRDA has woken up to these malpractices and disguised commission charges. Not only Allianz Bajaj policies, but also AVIVA policies will come under fire. IRDA has issued a notice to these insurance companies to withdraw these complex commission policies and replace them with more transparent policies within 15 days.

I would say IRDA has now started to do its real job – to regulate the insurance markets, commission charges and agents.

I would expect IRDA to further take disciplinary actions and instruct these companies to refund the charges that have taken so far on these insurance policies.

Most important and a better action would be to tighten the rules for selling the insurance policies – It would require defining strict guidelines for insurance agents who sell these policies without even they themselves understanding it. Best would be to have a certification exam from IRDA, only after qualifying the exam should a person be eligible to sell the policies. Presently, any person with a 12^th class qualification can become a LIC agent. When educated engineers, doctors, etc. in metro cities are not able to understand the policy terms and conditions, imagine how the situation would be in small towns where people are not that well versed with finance. Agents exploit them to a much larger extent. If the insurance companies are penalized for floating such complex policies, even the agents should be penalized for selling these – by a partial refund of their commissions to the policy holder.

I would like to follow up on this article from the people who have bought such policies. Maybe you’ll get a notification from your insurance company in a few days, mentioning the withdrawal or replacement of your existing policy. Please do let me know what is given to you – a new policy or a sum of money. I will be happy to analyze if things have improved or worsen or remained the same. Please post the details in the comments section.

Keep visiting this blog for further content.

Please read the comments and post your views and queries in the comments section which helps in open discussion and avoid duplicity of questions.

You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.

Compounded Interest rates: The magic of compounding - Part I

Very often we hear this term: Compounded interest rates. What is it and how it really works?

Let’s look into details of this because this term is widely used across all kinds of investments: Banks, Fixed deposits, PPF, even stock markets and other forms of businesses. In this article, I’ll also illustrate how our investments in stocks, FD etc. are affected by compounded interest rates or returns.

Assume that you have 10,000 dollars. There is a special bank account (say of type A) that is offering you 10% interest rate compounded annually while there is another bank account that is offering you same 10% interest rate, not compounded, but simple interest rate (say of type B).

So, suppose you decide to invest 10,000 each in both these accounts and you want to remain invested for 10 years long period. Since bank account A offers you compounded interest rates, the interest earned in year 1 will add to your principle amount of 10K, and this total will become the principal for next year.

This is how your money will grow in bank account A for the next 10 years:

Year	Total	Interest	Net after Interest
1.00	10,000.00	10%	11,000.00
2.00	11,000.00	10%	12,100.00
3.00	12,100.00	10%	13,310.00
4.00	13,310.00	10%	14,641.00
5.00	14,641.00	10%	16,105.10
6.00	16,105.10	10%	17,715.61
7.00	17,715.61	10%	19,487.17
8.00	19,487.17	10%	21,435.89
9.00	21,435.89	10%	23,579.48
10.00	23,579.48	10%	25,937.42

In case of account B, the interest earned in year one will not be added to your principle amount of 10K. Instead it will be paid to you. Hence, your eligible principle for each year will remain 10K and this is how it will grow in bank account B:

Year	Total	Interest	Net after Interest	Income
1.00	10,000.00	10%	11,000.00	1,000.00
2.00	10,000.00	10%	11,000.00	1,000.00
3.00	10,000.00	10%	11,000.00	1,000.00
4.00	10,000.00	10%	11,000.00	1,000.00
5.00	10,000.00	10%	11,000.00	1,000.00
6.00	10,000.00	10%	11,000.00	1,000.00
7.00	10,000.00	10%	11,000.00	1,000.00
8.00	10,000.00	10%	11,000.00	1,000.00
9.00	10,000.00	10%	11,000.00	1,000.00
10.00	10,000.00	10%	11,000.00	1,000.00
			Total Income	10,000.00

Therefore, at the end of the 10^th year, you will get back your original principle amount of 10K and over these 10 years, you would earn 1000 Rs. each year (as interest), so your total will be 10K + 10K = 20K.

Now compare the total maturity amounts from the 2 different bank accounts A & B. Bank account A with compounded interest option gives you 25,937 $, while simple interest account B gives you only 20,000 $. Definitely, in terms of money earned, you are getting more in compounded interest option.

In terms of percentage gains, income from compounded interest bank account is 30% higher than that from simple interest. Hence, this appears to be a more attractive option.

However, nothing in this world comes for free. The 30% extra income that you are receiving from compounded interest comes at a cost. The cost is in the form of loss of freedom and access to both the principle amount and for the interest earned. For compounded interest amounts, you cannot withdraw your principle amount of 10K or any of your interest earned during the entire investment horizon of 10 years. While in case of simple interest account, your principle may be locked, but you have freedom to utilize the interest amount of 1000 each year.

When we think about long term investments, we are basically willing to forego the invested money for the entire investment horizon. If that is the case, then it’s always better to opt for compounded interest. For e.g., when you open a fixed deposit account (FD), you have the option to specify how do you want your interest to work

• Interest should be reinvested (Compounded Interest)
• Interest should be paid to you (Simple Interest)

Another example that can be quoted here is of the tax saving bonds. These bonds come with a lock in period of 3 years and pay the interest annually. So at the end of each year, you receive a check (cheque) for the interest amount you earned on your investment. Therefore, this interest amount does not add up to your principle and hence your investment in bonds becomes that of a simple interest account.

So depending upon your need, you should select the right option.

Now, let’s get into some more details, carrying forward the same discussion to stocks, mutual funds and other forms of investments. We usually hear these kinds of statements, from novice investors, business experts and guest speakers on business news channels:

“Stock Markets are giving 15% returns each year”

OR

“Stock returns have been excellent since we are seeing 20% profit in stocks each year for the last 10 years”

These statements are quite commonly heard. But what’s the truth and how does it really work?

Continue to Part II of this article