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Understanding Dilution
Once upon a time, not very long ago, Indian investors loved companies that liked to visit the capital markets regularly to raise equity capital. The mere announcement of prominent companies' plans to tap the markets in the near future was enough to make their stock prices zoom up. For, investors were eager to invest in companies that could dream up grand projects that required huge amounts of capital. The earnings of such companies, that were generated by pouring capital into capital-intensive projects were assigned high price-earnings ratios. The pendulum has now swung the other way. Today, companies who visit the capital market are shunned by investors. The mere announcement of a company's plans to tap the market is enough for its stock price to plummet. Investors expect companies to finance their growth through internally generated funds. The term "earnings per share dilution" has become a dirty word in the Indian stockmarkets. Earnings Per Share Dilution The earnings per share (EPS) of a company in any given year 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 its per-share earnings. This fall in earnings per share is referred to as "earnings per share dilution" or "EPS dilution" or "equity dilution." Is an earnings per share dilution a bad news for the company's shareholders? Not always. Intrinsic Value Dilution What matters is not EPS dilution but "intrinsic value per share dilution." In many cases, a dilution in EPS is accompanied by a dilution in per-share intrinsic value. This would happen, for example, when a company's promoters allot shares to themselves at a heavy discount to their per-share intrinsic value. But it is vital for investors to understand that all EPS dilutions do not necessarily result in per-share intrinsic value dilutions. Understanding the difference between EPS dilution and intrinsic value dilution is as important for managers as it is for investors. Managers should act in ways that increase intrinsic value per share and avoid moves that decrease it. Moreover, their focus should be on maximising per share intrinsic value, not per share earnings. These two goals do not always go together. Many managerial acts may reduce EPS while increasing per-share intrinsic value and conversely many managerial acts may increase EPS but reduce intrinsic value per share. To understand the difference, think of a 25-year-old-first-year MBA student who is currently earning nothing. His "earnings per share" is nil. However, a peon working in his educational institution, who is a wage earner has a positive "earnings per share." Now, imagine that both of them agree to share their future earnings equally as long as they live. Such an agreement would immediately increase the EPS of the MBA student in a big way but will immediately reduce his per-share intrinsic value. Many managers believe that if they can figure out a way to boost EPS for the current or the next few years, their companies' stock prices will always go up. They are wrong. Although EPS is useful for some situations, its simplicity allows managers to ignore important factors that affect the value of a company. It can, therefore, lead managers to make choices that destroy value in the long term, often without the shortterm share price improvement they hoped for. Conversely, there can be many situations where a fall in EPS may actually be accompanied by a rise in per-share intrinsic value.
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Many managers forget that while they can take decisions that affect EPS, it is the market that will determine the price earnings ratio (P/E) and, consequently, the stock price. So, if an irrational managerial decision increases EPS but reduces per share intrinsic value, the market will punish the company by assigning it a low P/E multiple. Conversely, if a sensible managerial decision reduces EPS but increases per-share intrinsic value, the market will reward the company by increasing its P/E ratio. Here are a few examples of irrational managerial actions that focus on EPS, instead of intrinsic value per share: I have divided these examples into three categories - operating, financing and merger/acquisition. Operating Decisions Example 1: Many pharmaceutical companies such as Ranbaxy Laboratories Limited spend huge sums of money in research and development activities. In many cases, R & D activities account for as much as 10% of annual sales. The economic rationale behind such expenditure is to develop new drugs that will become future cash cows as current drugs move out of patent protection. Now suppose, Ranbaxy decides to stop all research and development activities. What would be the result? There will be two consequences. One, a huge increase in profitability of the current and the next few years. And two, an eventual decay of earnings over the long term. Overall, such a move would be disastrous for the company's shareholders and will immediately reduce its per-share intrinsic value. That's because the intrinsic value of the business of Ranbaxy is the present value of all its future earnings. If current and near-term earnings rise but long-term earnings decline, it is possible that the per-share intrinsic value will fall significantly. Example 2: 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. Example 3: Imagine a financial institution (FI) holding a large investment portfolio. Suppose, in that portfolio, there is a significant investment in the shares of a sound, well managed company that the FI bought for Rs 100 per share having an intrinsic value of Rs 200 per share. The current market price, however, is only Rs 50 per share. Under these circumstances, the rational decision would be to sell the shares at Rs 50 and immediately buy them back. Such a decision would have three consequences. First, it would result in an accounting loss of Rs 50 per share. Second, because the accounting loss is tax deductible, it could be adjusted against profits made from other security transactions resulting in tax savings in the current year. And third, when the shares are eventually sold after a few years - say, at Rs 250 per share, then the FI would have to pay a higher tax bill than it would have, had it not entered into this transaction. The end result of the second and the third points 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? In my opinion, very few indeed. Nevertheless, such managers do exist, and investors should seek them out. Financing Decisions Example 1: 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
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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. Example 2: Suppose there is well managed company that earns high returns on its capital. Assume that its product is in great demand and it wishes to increase capacity to meet that demand. The management is conservative and does not want to increase its total debt. Under these circumstances, the only other option the company has is to raise funds through an offering of shares. As long as the additional shares of the company are sold in the market for cash at a price that is not less than the per-share intrinsic value, the existing shareholders will gain, and not lose from this proposition. Even if the shares are issued to nonshareholders by way of a private placement or GDR issue or preferential allotment, so long as the price at which the shares are sold is at least equal to the per-share intrinsic value, the decision would be sensible even though current EPS will fall. Put simply, this means that so long as the returns from new capital raised are sufficiently attractive, the company's shareholders would be better off with the prospect of owning a smaller share of a larger pie than a larger share of a smaller pie. Suppose, this company's managers got worried about EPS dilution and dropped the plans for expanding capacity. Such a decision would actually hurt the shareholders, not help them. That's because another competing company could expand its capacity and grab market share from this company. While near-term EPS may not get diluted, the market will respond by reducing the P/E multiple. EPS dilution is a price well worth paying for an increase in per-share intrinsic value. 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." Another example: In analysing business acquisitions, many managers, investors, and analysts tend to incorrectly focus on whether the transaction is immediately dilutive or anti-dilutive to EPS. Consider an acquisition in which a company selling for a high price-earning (P/E) multiple buys a firm selling for a low P/E ratio by exchanging shares. Because fewer of the high P/E shares are needed to retire all outstanding low P/E shares, the buyer's EPS will always increase. Many investors as well as analysts think that this is good news for the buyer's shareholders. To see how silly this preoccupation with EPS is, reverse the transaction so that now the low P/E firm buys a high-multiple company through a share exchange. This time the buyer's EPS must always decrease; a greater number of low-multiple shares will have to be issued to retire all the high-multiple ones. Many think that such EPS dilution signals bad news for the buying company's shareholders and advise that it be avoided at all costs. But regardless of which company buys or which sells, the merged company will be the same, with the same assets, prospects, risks, earnings, and value. Can a transaction really be desirable if it is consummated in one direction but not in the other? Of course not. Yet, that is what many investors an
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analysts mistakenly believe. 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. An example would explain. Many closed-ended mutual funds in India are quoted in the market at heavy discounts to their net-asset values. One of the options available to the mutual fund managers of such funds is to simply buy back their shares in the market at deep discounts and then cancel those shares. Such an action would instantly increase the net asset value of the remaining shares. But mutual fund managers are reluctant to take such wealth-enhancing decisions because of an important conflict of interest. If they were to buy back the shares, it would amount a reduction in the size of their fund and, consequently, in the size of the management fees. Is it any wonder that huge discounts exist in the quoted price of these mutual funds? 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. Both managements and investors should ask themselves a very simple question: What's more important, an increase in EPS or an increase in stock price? Perhaps the mission statement of one value-oriented company would help them make up their mind: "The objective of our company is to increase the intrinsic value of our equity shares. We are not in business to grow bigger for the sake of size, nor to become more diversified, not to make the most or the best of anything, nor to provide jobs, have the most modern plants, the happiest customers, lead in new product development, or achieve any other status which has no relation to the economic use of capital. Any or all of these may be, from time to time, a means to our objective, but means and ends must never be confused. We are in the business solely to improve the inherent value of the shareholders' equity in the company." Note This article is submitted by Sanjay Bakshi who is the Chief Executive Officer of a New Delhi based company called Corporate Investment Research Private Limited. Sanjay Bakshi. 1996.

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