Neither a bonus issue nor dividend can boost the LIC share, which opened at a discount and is now trading at about 20 per cent less than the issue price
The initial public offering (IPO) of LIC of India was successfully marketed to the public. But the subscribers to the issue are facing the stark reality of a beaten down stock in the stock exchange. As we had discussed earlier, even before the issue was opened to the public as well as after the first day of listing, the reason for drubbing in the market is on account of unrealistic pricing of the issue.
It has not taken into account how the other life insurance companies have been valued in the market for the past couple years in terms of the price-earning ratio or book value-to-price ratio. Any benchmarking should be realistic; arbitrary and irrelevant benchmarking of any IPO is always a disaster. This is what has happened to the IPO of LIC of India.
The closing price of LIC share was Rs 738.05 in NSE on 08 06 2022 whereas the issue price was Rs 949. This means that the present share price is down by more than 22 percent of its IPO price.
Now on seeing the drubbing in the market, various suggestions emanate to prop up the price in the market. The suggestions include a bonus issue and special dividend by the company. The advocates of these suggestions do not understand that these suggestions cannot increase the intrinsic value of the company and the market price and the intrinsic value are interrelated.
The market price of any company share is decided by the earning potential of the company. The bonus issue or special dividend cannot increase the earning potential of any company. In fact, any dividend outgo will reduce the ability of the company to earn further on the amount.
Bonus issue
A bonus issue of shares is the stock issued by a company in lieu of cash dividends. Shareholders can sell the shares to meet their liquidity needs. Bonus issues are made available by transferring funds from reserve fund of the company to share capital. A company’s net worth is only its share capital plus free reserves, and hence bonus shares increase a company’s share capital but not its net assets.
The following example will show how bonus issue cannot make any fundamental difference to its valuation.
A company with the issued number of shares of 1,000, share capital of Rs 10,000, reserves of Rs 50,000, and a net profit of Rs 6,000 (which is quoted at the PE ratio of 10) issues bonus shares in the ratio of one is to one, the position will be as follows before and after issue of bonus shares:
After the bonus issue, the total number of shares will go up from 1,000 to 2,000, share capital from Rs 10,000 to Rs 20,000, and reserves from Rs 50,000 to Rs 40,000. The net worth (capital plus reserves), however, stays the same Rs 60,000. Similarly, net profit remains Rs 6,000. The earnings per share declines from Rs 6 to Rs 3.
The book value comes down from Rs 60 to Rs 30.
When market capitalization and the price-to-book value ratio do not change, the shareholders’ value stay the same. Of course, sometimes market may view the bonus issue as a positive factor, but that will be false exuberance as fundamentals of the company do not change.
Dividend
Any dividend declared will be an outflow from the company and to that extent it will reduce its earning capacity. The dividend paid does not make the company earn more; this cannot influence the market price of the share. Hence it will be a futile attempt to declare a dividend by LIC to prop up the share price. If any dividend is declared, the share price will fall after the ex-dividend date.
Rights issue
Knowingly or unknowingly, LIC of India has made its IPO at an unreasonable price. Being an organisation owned by the government of India, the government now cannot close its eyes to the misery of retail investors who subscribed to its IPO. Leaving the retail shareholders to fend for themselves may not be good for the government which is going to disinvest in other Government companies.
A way out to help the retail investors can be by way of a rights issue. The rights issue will be an invitation to the existing shareholders to buy new shares in proportion to their existing shareholding. The Government has sold just 3.5 per cent of its share in LIC of India.
If a rights issue is made and the Government also opts out from subscribing to the same, all new shareholders can subscribe to the same. If the rights issue is made with a good discount from its prevailing market price, it can attract a good subscription.
For example, if the market price is Rs 800, LIC can offer the rights issue at the ratio of one is to one (1:1) with a price of Rs 400. This will compensate the existing shareholders, as their per-share investment will come down drastically and the market can also be upbeat about this issue. Even if any shareholder cannot subscribe for the rights issue, she can renounce the same at a price and make money.
With a rights issue, LIC can get a substantial premium and this will add up to its reserve and book value.
Originally, the government was planning to offload 5 per cent of its holding in LIC, but due to adverse market conditions the issue was only for 3.5 per cent of Government holding.
The rights issue can be an avenue to reduce Government holding further.
Hence with right pricing of the Rights issue, LIC can achieve multiple objectives.
(The writer is a retired banker. The views expressed are personal.)