When a company offers dividends and right shares, stock exchange generally responses that corporate action with the stock price adjustment of a corresponding company. What is the rationale for stock price adjustment and how is it done? This article is an attempt to answer both of these questions.
Rationale for Stock Price Adjustment
Stock Dividend : Stock Price Adjustment
Right Share Offering : Stock Price Adjustment
Cash Dividend : Stock Price Adjustment
Rationale for Price Adjustment
Most notably there are five corporate actions that leads to stock price adjustment. They are cash dividend, stock dividend, right offering, stock split and buybacks.
Cash dividend, stock dividend and buybacks deplete corporate reserves, while right offering increases corporate reserves. Likewise, stock dividend, right offering, and stock split increase the number of outstanding shares; while the buybacks decrease the number of outstanding shares.
In nutshell, these corporate actions outlined above directly affect the reserves and number of outstanding shares of companies. Therefore, price adjustment takes place to reflect these changes in the corporate reserves and outstanding shares.
In addition, stock price adjustment happens to keep the value of investment in stock unchanged after any corporate action that results from the alteration of balance sheet of the company.
Moreover, price adjustment justifies for providing actual and accurate stock price to the new investors deprived of dividend and right offerings.
Price Adjustment in Case of Stock Dividend
When company offers stock dividend, usually a certain percentage of its outstanding shares, the value of company’s share price is adjusted based on the previous day’s closing price. Principally, the adjustment method off share price primarily rest on the fact that value of investment no longer be changed after the stock dividend (also bonus shares) offerings.
Value of Investments Before stock dividend (VIB) and Value of Investment After stock dividend (VIA) can be defined as:
VIB = OSB * LTP
VIA = (OSB + OSB * Percentage of Stock Dividend) * ASP
Where,
OSB = number of Outstanding Shares Before stock dividend
LTP = Last Trading Price (Previous Day’s Closing Price)
ASP = Adjusted Stock Price
In order to hold the assumption of unchanged value of investment before and after the stock dividend, following mathematical equality must satisfy.
Value of Investment Before stock dividend (VIB) = Value of Investment After stock dividend (VIA)
That means,
$$ {VIB} = {VIA}$$
This equality produces the following mathematical relation step by step when substituted the corresponding values.
OSB * LTP = (OSB + OSB * Percentage of Stock Dividend) * ASP
OSB * LTP = OSB (1 + Percentage of Stock Dividend) * ASP
LTP = (1 + Percentage of Stock Dividend) * ASP
Solving for the ASP, we get the formula for Adjusted Stock Price in case of stock dividend as follows:
$$\text{ASP} = \frac {\text{LTP}} {\text{1 + Percentage of Stock Dividend}}$$
That means the formula for adjusted stock price in case of stock dividend is
$$\text{Adjusted Stock Price} = \frac {\text{Last Trading Price}} {\text{1 + Percentage of Stock Dividend}}$$
Price Adjustment in Case of Right Shares Offerings
Stock price adjustment mechanism in this case is also similar to the case of stock dividend. However, in case of right offerings, company raises additional capital from the existing share holders. This additional capital raised from existing share holders also constitutes the investment. So, it is in-cooperated into the calculation of adjusted stock price.
The in-corporation of additional capital takes place directly in the Value of Investment Before right offerings (via addition) and indirectly in the Value of Investment After right offerings.
That means that equality equation becomes,
Value of Investment Before right offerings (VIB) + Additional Capital Raised (ACR) = Value of Investment After right offerings (VIA)
That means
$$ {VIB + ACR } = {VIA} $$
We can define VIB, ACR and VIA as follows:
VIB = OSB * LTP
ACR = (OSB * Percentage of Right Offerings) * Per Unit Price of Right Share
VIA = (OSB + OSB * Percentage of Right Offerings) * ASP
Where,
OSB = number of Outstanding Shares Before right offerings
LTP = Last Trading Price (Previous Day’s Closing Price)
ASP = Adjusted Stock Price
Placing the values in the equality equations VIB + ACR = VIA, we get the following mathematical relation to produce the formula for stock price adjustment in case of right offerings.
OSB * LTP + (OSB * Percentage of Right Offerings) * Per Unit Price of Right Share = (OSB + OSB * Percentage of Right Offerings) * ASP
OSB * ( LTP + Percentage of Right Offerings * Per Unit Price of Right Share) = OSB * ( 1 + Percentage of Right Offerings) * ASP
$$\text{ASP} = \frac {\text{LTP + Percentage of Right Offerings * Per Unit Price of Right Share}} {\text{1 + Percentage of Right Offerings}}$$
That means the formula for adjusted stock price in case of right offerings is
$$\text{Adjusted Stock Price} = \frac {\text{Last Trading Price + Percentage of Right Offerings * Per Unit Price of Right Share}} {\text{1 + Percentage of Right Offerings}}$$
Price Adjustment in Case of Cash Dividend
Stock price adjustment in case of cash dividend holds similar analogy to stock dividend. However, the price adjustment in case of cash dividend is only applicable if corporation provides more than ten percentage of cash dividend as per prevailing rules in Nepal.
In addition, stock split and buybacks are rare cases in Nepalese corporate scenarios, their detailed analyses of price adjustment mechanism are ruled out in this article. However, one can apply the similar analogy of price adjustment in the case of stock split and buybacks as well.
