Don’t trade the company flat for a flashy Ferrari

Companies issue equity all the time. It is considered a normal part of business.

In fact, when equity markets are doing well, chief executives often push for a rights issue, arguing that the market is overpriced and therefore it makes sense to issue new shares and sell them into the market.

That might seem to make sense at first blush. But if a chief executive thinks this makes commercial sense, they are being naive. The only other explanation is that they are less than honest. Let us explore why.

Why is selling something at a higher-than-value price incorrect? In general, if it is a non-producing asset, then there is nothing wrong with this.

Selling someone an overpriced pair of shoes should not cause any issues. But overpricing a producing asset is problematic.

Consider the sale of a second-hand Toyota Land Cruiser. If the market for second-hand Land Cruisers is Dh50,000 and someone sells one for that price to a buyer who simply wishes to use it for personal use, then this is a commercially sensible trade.

But what if the buyer is looking to turn around and rent out the Land Cruiser they purchased at Dh5,000 per month? In that case, the buyer has a commercial benefit far beyond simply the use of the Land Cruiser. They will make a lot of money. It might make commercial sense to negotiate in selling to them.

Consider too an owner of a residential building, whom we will call Khaled. Khaled wants to buy a Ferrari for his personal use from Saleh. Khaled, noticing that the real estate market is overheated, decides to swap one of the apartments in his building, at the inflated prices, for the Ferrari.

Khaled, and misguided chief executives, might believe that he has benefited by trading one asset at an overinflated price (the apartment) for another asset (the Ferrari).

The problem is that the apartment is a producing asset – it generates rent – and the Ferrari generates zero economic value. In fact, if you consider insurance, maintenance and extra petrol consumption, the economic value is negative.

As Khaled continues to market and improve his building, he generates continuing revenue improvements for Saleh without any effort on the part of Saleh. Khaled has sold himself into serfdom.

This brings us to the scenario of a company issuing shares because the chief executive deems the market price of the share as being expensive, and thereby assuming that issuing shares at the inflated market price makes sense.

The basic mistake that such a chief executive is making is misunderstanding the cost of equity. Equity has a massive cost – and not just because of the return on equity that shareholders might demand, although that is important.

With developed market equity premiums to government debt benchmarks averaging about 6 percentage points, this implies a 12 to 15 percentage point emerging market equity premium.

The main cost of equity issuance, though, is dilution of equity shareholder return. To understand this point, let us return to Khaled. What if Khaled, instead of trading away one of his apartments for the Ferrari, chooses instead to pledge the apartment to a bank in return for a loan that he uses to buy the Ferrari?

In this case, Khaled forfeits the economic benefit of the apartment for as long as the rent is needed to pay off the loan. But once the loan is paid off the economic benefit of the apartment reverts to Khaled.

Contrast that with irrevocably surrendering the economic benefit to Saleh. It does not seem like such a great idea now, does it?

What other options does a company have to raise cash? It could issue debt instead of equity. Or it could borrow directly from the banks. Certainly if the economic environment is so positive that the equity markets are positive then bank sentiment should be positive as well. Or it could simply wait and collect cash rather than give away equity.

Companies that are too quick to issue equity are usually driven by chief executives focused on self-aggrandisement and boards asleep at the wheel.

Their shares usually crash soon after. Shareholders are better served by longer-term thinking boards and management which focuses on retaining and growing shareholder value rather than diluting it.

Sabah Al Binali is an active investor and entrepreneurial leader, with a track record of financing, building and growing companies in the Mena region. You can read more of his thoughts at al-binali.com

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