The recent article I read "Understanding Dilution" by
Prof.Sanjay Bakshi, today would like to share my views on the same.
The article mostly talks about how dilution is taking place in the
capital market and how investors today are changing.
Long ago, investors were eager to invest in companies that could dream
up grand projects that require huge capital. The earnings that were generated
through capital into capital intensive projects were given higher
price-earnings ratios. But now there is a complete U turn in the way capital
market has been performing. Let’s see how this dilution has affected.
Earnings per share
Dilution:
EPS is arrived at by dividing its total earnings in that year by the
number of shares outstanding. Therefore, when a company issues additional
shares, the result is a fall in it’s per share.
This fall is referred to as “earnings per share dilution”.
Intrinsic Value per
share Dilution:
What matters is not EPS dilution but intrinsic value per share dilution.
Lets understand this difference.
A 25-year old first year MBA student who is currently earning nothing. His
EPS is nil & a peon working with the same educational institution being a
wage earner has a positive EPS. Now, imagine both of them agree to share their
future earnings, such agreement would immediately increase the EPs of the
student in a big way but will reduce his per-share intrinsic value.
Managers often forget that while they can take decisions that affect
EPS, it is the market that will determine the price earning ration and
consequently the stock price. So if an irrational managerial decision increases
EPs but reduces intrinsic value, the market will punish the company with low P/E
multiple. Conversely, if a sensible managerial decision reduces EPS but
increases intrinsic value the market will reward by an increase in P/E ratio.
Here are a few examples of irrational managerial actions that
focus on EPS, instead of intrinsic value per share:
1. Operating Decisions:
Hindustan Lever spent Rs 108 crores on advertising in 1995. That
expenditure accounted for 2.86% of its total sales for that year. Its pre-tax
profits for the year were Rs 372 crore. Suppose, HLL had instead decided to
stop all advertising Such a decision would have increased its pre-tax profits
by more than 25% for 1995 but would have significantly reduced its per-share
intrinsic value.
The end result is that cash outflows on account of taxation would be
delayed. This would increase the per-share intrinsic value of the business
while reducing its current accounting profits and EPS. How many managers do you
think would have the courage to take such a decision? Very few indeed.
2. Financing Decisions:
When a company needs funds for its business, it has only two sources -
equity and debt. Because, using debt does not result in an increase in the
number of outstanding shares, many managers prefer to finance growth out of
debt, basing their decisions on the favourable impact on the EPS of the
company. They forget that increasing debt also increases the risk of
bankruptcy. And markets punish companies that over-leverage their balance
sheets by assigning low price-earning multiples to their earnings. So, while
EPS may rise, a fall in the P/E ratio may nullify the effect of EPS increase on
the stock price.
3. Merger/Acquisition Decisions:
Many promoters run their businesses to build empires not to enhance
owners' wealth. Frequently, such managers take decisions that increase the size
of their company as well as its EPS but reduce its per-share intrinsic value.
Their behaviour can be explained by the following example coined by Warren
Buffett.
"If (1) your family owns a 120-acre farm and (2) you invite a
neighbour with 60 acres of comparable land to merge his farm into an equal
partnership - with you as managing partner, then (3) your managerial domain
will have grown to 180 acres but you will have permanently shrunk by 25% your
family's ownership interest in both acreage and crops. Managers who want to
expand their domain at the expense of owners might better consider a career in
government."
Double Whammy Effect:
Companies that are run by managers who do not focus on per-share
intrinsic value suffer from a "double whammy" effect. If, for
instance, such managers ignore actions that would increase per-share intrinsic
value, they would be punished by the markets for ignoring sensible decisions by
assigning them a low a price-earning multiple for having missed important
opportunities of enhancing owners' wealth. On top of this, the company will
also be downgraded on another ground. For, rational investors would not pay as
much for the assets lodged in the hands of a management that has a record of
wealth-destruction by ignoring such opportunities.
Conclusion:
Managements should focus on maximising the value of their companies, not
their earnings per share. Investors should insist on managements who act in
ways that increase per-share intrinsic value and avoid ways that reduce it.
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