June 11, 2009

Capital raising - an exercise for whom?

I have been tracking stocks for the past few years and should say, through the ups and downs, it has been truly a wonderful experience. As an analyst, reading balance sheets, macro data, quarterly results and corporate actions has always been a delight.

Over the past few months, I have been getting increasingly perturbed with the concept of capital raising. It is a necessary exercise especially for companies that would like to grow beyond their current capacity. Capital is needed for companies for different reasons - funding growth or reduce risk residing in the balance sheet. Few examples
  • Construction companies need higher networth to bid for bigger projects and fund their working capital.
  • Banks need capital to fund balance sheet growth when internal accruals does not support them. Further, capital is raised when risk was mispriced leading to substantial erosion of profitability and raising threat of survival
  • Capex driven industry (infrastructure) need higher networth to reduce risk in the balance sheet.

So, given this simple broad utilisations of networth, we need to understand the valuation behind raising capital and how should investors look at this exercise. We continue to see a capital raising activity to be extremely favourable to investors. Is there a logic to this argument.

To understand this, we assume that investors value companies in two broad valuation metrics: Price/Earnings and Price/Book.

Price/earnings can be dilutive to some extent to investors depending on the extent and price of dilution as investors play for growth more than return on equity (typically RoE in these industries are much higher than the cost of equity). Hence, I have not looked into this that deeply.

We take four specific illustration to understand this argument:
1. Raising at below book value: The book value per share declines depending on the extent of discount. This will be a poor policy, if implemented and can be done only when the possibility of erosion of networth is possible as the existing shareholders are not adequately compensated with the entry of the new investor.

2. Raising at book value: The book value per share remains constant and the new and old shareholders are not compensated with the change in shareholding structure.

3. Raising at fair book value: This is favorable to existing shareholders as there is an improvement in book value per share. The only assumption made here is that the new investors are bringing equity to the business which can impact the return on equity in the medium term. The reason is as follows.
  • If price were to remain constant at the fair book multiple, the expansion in book value per share will depress the new price/book multiple.This is acceptable sometimes as it would take sometime for the company to sweat the new capital raised.
  • If the price/book ratio were to remain constant, the price increases. However, this increase impacts both the existing shareholder as well as the new shareholder immediately, which should not be the case, as it gives endless arbitrage opportunity to keep raising capital.
4. Raising at exorbitant book value: This is the most puzzling and the most complex form to understand. Why do investors raise capital beyond fair multiple as the only person benefiting from it are existing investors? There are can be very few reasons for this.

Company like raising money by diluting as little as possible. This is not a valid argument as they are transfering risk to new investors. If this is a reason, then investors should be really wary of playing the game. New and old investors are banking on the ability of the existing company to keep bringing in new investor and artificially keeping their stock prices higher than the fundamentals warrant. Stock prices will be inherently volatile in these stocks as raising capital frequently and consistently will be a challenge.

New investors are not given immediate opportunity to play with the old investors. This is a much reasonable investment argument. The bulk of the risk was taken by the old investors and new investors are coming having seen the performance, which implies that new and old investors have two different cost of equity. The promoter and initial investors have borne the brunt of risk when they had invested while the new investors are just playing the final leg of the game. Hence, they are being punished for not entering early.

Investors understand that sustainable RoE can see further expansion but markets are unwilling to look at these factors. Hence the new investors are playing that risk.

There are arguments of scarcity premium, management premium, country premium etc etc but how much premium and where are these getting factored to the price is always the question.

Having written this, I have become no wiser than ever before. If anything, I seem to be as confused as ever.

1 comment:

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