When a company offers dividends and right shares, the stock exchange generally responds to that corporate action by adjusting the stock price of the corresponding company. What is the rationale for stock price adjustment, and how is it done? This article attempts 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 five corporate actions lead to stock price adjustment. They are cash dividends, stock dividends, right offering, stock split, and buybacks.
Cash dividends, stock dividends, and buybacks deplete corporate reserves, while the right offering increases corporate reserves. Likewise, stock dividends, right offering, and stock splits increase the number of outstanding shares, while buybacks decrease the number of outstanding shares.
In a nutshell, these corporate actions outlined above directly affect companies’ reserves and number of outstanding shares. Therefore, price adjustments are made to reflect these changes incorporate reserves and outstanding shares.
In addition, stock price adjustment keeps the value of stock investments unchanged after any corporate action that results from altering the company’s balance sheet.
Moreover, price adjustment justifies providing actual and accurate stock prices to the new investors deprived of dividends and the right offerings.
Price Adjustment in Case of Stock Dividend
When a company offers a stock dividend, usually a certain percentage of its outstanding shares, the value of the company’s share price is adjusted based on the previous day’s closing price. The adjustment method of share price primarily rests on the fact that the value of investment no longer changes 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
To hold the assumption of the unchanged value of investment before and after the stock dividend, the following mathematical equality must be satisfied.
Value of Investment Before stock dividend (VIB) = Value of Investment After stock dividend (VIA)
That means,
$$ {VIB} = {VIA}$$
The substitution of corresponding values results in the following mathematical relation.
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 the case of stock dividends is
$$\text{Adjusted Stock Price} = \frac {\text{Last Trading Price}} {\text{1 + Percentage of Stock Dividend}}$$
Price Adjustment in Case of Right Shares Offerings
The stock price adjustment mechanism is similar to that of stock dividends. However, in the case of the right offerings, a company raises additional capital from existing shareholders. This additional capital also constitutes the investment, so it is incorporated into the calculation of the adjusted stock price.
The incorporation 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 the 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 the 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 the case of cash dividends is similar to stock dividends. However, the price adjustment in the case of cash dividends is only applicable if the corporation provides more than ten percent of cash dividends as per the prevailing rules in Nepal.
In addition, stock splits and buybacks are rare cases in Nepalese corporate scenarios, so this article excludes detailed analyses of price adjustment mechanisms for them. However, one can apply a similar analogy of price adjustment to them as well.