The es­sen­tials of shares

Finweek English Edition - - Marketplace - Ed­i­to­rial@fin­week.co.za

wWhile tech­ni­cal terms might sound over­whelm­ing, they are of­ten sim­ple to un­der­stand – and very im­por­tant.

hat’s the dif­fer­ence be­tween au­tho­rised and is­sued shares? What are share buy­backs and trea­sury shares? It might sound like lots of jar­gon, but as is of­ten the case, these are im­por­tant terms that are sim­ple to un­der­stand.

Let’s start right at the be­gin­ning. When a com­pany is formed (whether pri­vate or listed) the founders will de­cide on an ini­tial num­ber of shares. These are the au­tho­rised shares, in other words those that have been au­tho­rised by the own­ers.

How­ever, the own­ers may elect not to is­sue all the au­tho­rised shares, keep­ing some in re­serve for later use. So, for ex­am­ple a new com­pany starts life with 1 200 au­tho­rised shares but only is­sues 900 of them. These 900 shares are the ones that are trad­able on the ex­change and will be used to de­ter­mine the mar­ket cap­i­tal­i­sa­tion of the busi­ness. (Mar­ket cap is cal­cu­lated as fol­lows: the num­ber of is­sued shares x share price = value of com­pany.)

The re­main­ing 300 shares can only be used (is­sued) with share­holder ap­proval and could be used to raise cash (sell the shares into the mar­ket and the com­pany re­ceives the money). Al­ter­na­tively, they could be used (again only with share­holder ap­proval) in lieu of money when buy­ing as­sets or pay­ing debts or even to pay di­rec­tor bonuses.

For ex­am­ple, the com­pany wants to buy out a com­peti­tor and, in­stead of us­ing cash it uses 100 of the un-is­sued shares. It means the peo­ple who sold their com­pany now own 100 of the now 1 000 is­sued shares – the ini­tial 900 plus the newly is­sued 100. The po­ten­tial con­cern here is that you will have es­sen­tially given away a part of the com­pany whereas if you pay cash for the com­peti­tor you just bought, it is a one-off pay­ment. The shares would be an ev­er­last­ing pay­ment. How this works is that at the an­nual gen­eral meet­ing (AGM) the di­rec­tors will re­quest au­thor­ity from share­hold­ers to use a spe­cific num­ber of the un-is­sued shares for transactions, even if they have no im­me­di­ate plans for them. This means that they have the au­thor­ity to use the shares and don’t have to get share­holder ap­proval ev­ery time they want to trans­act. Au­thor­ity is gen­er­ally given for a lim­ited num­ber of shares so that di­rec­tors can do medium-sized deals but would re­quire ad­di­tional ap­proval for huge deals. A com­pany can, of course, again with share­holder ap­proval, in­crease the num­ber of au­tho­rised shares in or­der to is­sue a larger num­ber to in­vestors.

Then we have share buy­backs. If the di­rec­tors feel that the com­pany’s share price is well be­low their per­ceived fair value and they have free cash that they don’t see any im­me­di­ate use for, they can start a share buy­back pro­gramme. They would once again need share­holder ap­proval and if it is granted, they would buy back the shares in the open mar­ket. These pur­chased shares be­come trea­sury shares un­til such time as they are “de­stroyed” – ef­fec­tively mean­ing they will no longer ex­ist.

The net re­sult here is to in­crease the value of the re­main­ing shares in the mar­ket. Let’s go back to our ex­am­ple of the above com­pany that now has

1 000 is­sued shares. Let’s say they’re trad­ing at R100 each. That would give the com­pany a value (mar­ket cap) of R100 000. If the com­pany now buys back 200 shares there would be 800 is­sued shares left. As­sum­ing all else is equal, the com­pany is still worth R100 000 but each share would have a value of R125 as there are 200 fewer shares with rights to the com­pany’s value of R100 000. Of course, it doesn’t al­ways work as smoothly as that. The com­pany has spent money to buy back the shares, mean­ing that it has less cash and as such the value of the com­pany would have de­creased, but in the longer term it can add value to the re­main­ing shares. ■

The com­pany has spent money to buy back the shares, mean­ing that it has less cash and as such the value of the com­pany would have de­creased, but in the longer term it can add value to the re­main­ing shares.

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