Under the Companies Act as well as common law, a shareholder in a public company is entitled to certain benefits. Some of these benefits are more illusory than real and we can ignore them. The real benefits in so far as a typical small investor is concerned, are as follows:
(a) He is entitled to sell his shares anytime he sees fit.
(b) He is entitled to take up any rights issue in proportion ash. ownership of the company.
(c) He is entitled to a share of the dividend declared in proportion is his ownership of the company’s issued shares.
(d) In the event of the liquidation of the company, either voluntary or forced, he is entitled to a share of the assets after all creditors have been paid off in proportion to his ownership of the company’s issued shares.
Let us look at each of these benefits in detail. Benefit (a) is clear enough. If, at any time, a shareholder is not satisfied with the way the company is run or if he thinks the shares of the company are men valued, he can sell his shares on the open market.
Benefit (b) is very important but its importance is by no means dear to the typical investor. This right is essential because it protects the existing shareholders of a company against what is known as dilution. In olden days when rights issues were the only type of new issue made by a company, this right protected the rights of the existing share holders. For if this rule did not exist, a company could issue as many shares to third parties as it liked and the percentage ownership of the existing shareholders would rapidly shrink. With the existence of this rule, it means that any new shares to be created must first be offered to the shareholders who had the rights of first refusal. This way the interest of the pre-existing shareholders will not be diluted.
However under the present condition, most companies can virtually create as many new shares as they like to be used in exchange of‘otheI assets. If the new assets “bought” with the newly created shares are too expensive or provide very low return, the per share earning power of the company would be reduced (it: diluted). Benefits (c) and (d) are not so clear-cut and yet their underlying principles are crucial to the understanding of the basis on which shares should be valued. ‘What are these underlying principles?
First, investors must realise that a share is so named because it entitles its owner to share in the benefits of the ownership. Whatever
Value of the company or whatever profit the company makes has to be shared out among all existing shareholders in proportion to their individual shareholding.
It is vital that you should understand this principle since shares are bought and sold based on its individual value. The value of an individual share depends on two things the overall size of the company and the number of shares there are..The total value of the company divided by the number of shares gives the value of each individual share. It is immaterial to the investor whether the company is worth $10 million or $1,000 million. What is important to him is the worth of one share. The shares of a small company, with only a few shares outstanding, can be worth considerably more than those of a large company. You may be interested to know‘ that in 1977, the shares of a small Californian oil company, Belridge Oil, were sold to Shell for US$100,000 each! The importance of understanding the difference per share value as against the overall value of a company cannot be over-emphasised. A share that is selling at a low price (ie less than $1.00) is not necessarily cheap. A share of AMDB purchased in 1982 at $0.85 is still worth only 3085 today. But a share of Rothmans (M) purchased at $2.00 at the same date is worth some $10.00 (all prices quoted are adjusted for bonus and rights issue). One share of Berkshire Hathaway, a company controlled by Warren Buffett, is selling at US$3,000.
In order to illustrate this point further, let us look at the value of the shares of Asiatic Development and Kuala Sidim, two plantation companies of very roughly equal size. Other things being equal, one hectare of plantation owned by Asiatic Development and one hectare of plantation owned by Kuala Sidim should be roughly the same. However, Asiatic Development has six and a half times more shares outstanding than Kuala Sidim. As a result, each 1000 shares of Asiatic Development are backed by 0.03 hectare but 1,000 shares of Kuala Sidim are backed by 0.34 hectares (ie 11 times as much). I am always being told that the shares of Asiatic Development are very cheap but compared to Kuala Sidim on an area per share basis, its shares are five times more expensive at their respective prices at the time of writing the book!
Similarly, what is important to the shareholders is the per share benefit Asiatic Development which can be obtained rather than the overall benefit to the company. It is not sufficient to know that the company makes 6 million dollars a year if a person owns only 1,000 of the 600 million shares in existence. The benefit to him after dividing the profit among 600 million shares will be too small (36 million per
600 million shares equals to only 1. cent per share or Sill per lot) it Is the failure to understand this principle that has caused the shares also many companies to become periodically overvalued to such an extreme extent as it is with some shares at the time of’ market peaks in 1981 or 1984. An example will make this principle clear. In 1983, the shares a! Supreme Corporation were bidded up to an extremely high level following an announcement that the company expected to make 1 total profit of M$500 million over the next ten years in housing development. M$500 million sounds like a lot of’ money but what is the per share benefit? Firstly, if we divide the expected profit into 10 years, we get an average expected profit of M$50 million a year. We then divide the M$50 million into the amount of shares of’ Supreme, which is 242 million. From this, we obtain the fact that on a per share basis, Supreme is expecting to make just over twenty cents profit per year. Twenty cents per share per year of pre-tax profit is hardly spectacular. As a comparison, Rothmans makes nearly four times as much at that time. This certainly puts the situation in a much better perspective. In the event, Supreme has not managed to make even a small fraction of the $500 million.
Secondly, investors must realise that what they are sharing is any dividend which may be declared by the company. Profit per se is of no immediate benefit to him as a shareholder. As one well-known Wall Street saying goes: ‘You cannot eat profit’. For a company to survive and expand, a large proportion or even all the profit may have to be retained in the company for the purchase of additional assets. While it is true to say that the profit so invested will increase the value of the shares of the company, it is better to believe that ‘a bird in hand is wort/f two in the bush’. More important, can you trust the management of most local companies to invest in assets which will bring the companies high future return. The local corporate scene is full of’ examples of come panics, which after being successful in one particular business through connections or good fortune, then proceed to invest heavily in another business at the most unsuitable time and/or at the highest possible price. A prime example of this is the investment of Genting in Asiatic Development. I would much rather the companies I have invested in, if they are profitable, to pay out their surplus to me in the form of dividend and then let me be the judge of how best that money should be invested. The future is very uncertain. What is of greater importance to the shareholders is the immediate benefit in the form of’ dividends which is paid out by the company. It may be of interest for local investors to know that all of the most widely accepted valuation methods used in the West are based on dividend or a close substitute rather than on profit.
Thirdly, the value of the assets of the company is only of real importance if the company is to be liquidated. What is important to the shareholders in the normal situation is how these assets of the company is utilised to generate profit which can be paid out to the shareholders. Take the case of the revaluation of the assets of Dunlop Estates (in 1983) to reflect the value of its land from a market point of new. Because of this revaluation and the subsequent bonus issue, the price of DEB rose to a level far above what is justifiable on the current agricultural earnings prospect. In this connection, two important issues are to be noted, apart from the fact that some people may well dispute the basis of valuation. First, the value of the estates as real properties is only of interest to the shareholders if DEB ceases to exist as an estate company and disposes of all its estates at once. Do you think this is politically feasible even though it may be commercially viable? Would the government accept the loss of jobs and agricultural production that Would ensue? Second, can the market absorb the sudden release of 50,000 acres of new land for development all at once? If the answers to the above questions are ‘No’, can one therefore value the shares of DEB as real properties instead of on the earnings prospect? It is Suggested that the only way the shareholders of DEB can enjoy the benefits of the value of DEB’s estate as housing land is for the company to release a small proportion of the total acreage on a yearly basis. The profit so obtained is likely to be small compared with the agricultural profit. For the foreseeable future, the value of DEB’s shares must still be largely based on its principal business, that of a plantation company. One is to remember that as its estates are disposed, its agricultural mung: will decline and the basis of valuation must be adjusted accordingly. The valuation of DEB or any other plantation company, for that matter, is a very difficult exercise and cannot be purely based on the value of its land holdings alone.
These three principles are to be borne in mind when you read the subsequent chapters of this book. In any case, these principles will be enlarged upon in subsequent chapters.