Pledging of Shares by Promoters and How it Impacts Stock Valuation

No. If a company has a high promoter holding, then pledging promoter’s shares is a common practice. You take a home loan to buy a house or a car loan to buy a car, right?

There is nothing bad about it but it is an indication that you do not have funds to purchase them upright and are willing to pay interest to avail of a loan for the purchase.

Similarly, if a company has pledged the promoter’s shares, then it is an indication that it might be in troubled waters (financially).

How Does It Work?

The bank or financial institution offering a loan to the company with promoter’s shares as collateral usually offer loans in a manner that it can sell those shares if there is a default made by the company and recover its dues. Here is an example:

Company A wants a bank loan for its expansion plans and is willing to pledge promoter’s shares for the same. The market price of the share is Rs.100. The company needs a loan of Rs.50 lakh.

The bank usually offers a loan of up to 50% of the market price of the share. So, if the company pledges one share, the bank will offer a loan of Rs.50. Since the company needs Rs.50 lakh, it will have to pledge 1 lakh promoter’s shares with the bank. 

The difference between the loan amount and the market price is kept by the bank as security. If the market price falls, then the bank asks the company to deposit more security or pay cash and reduce the loan liability to maintain the margin.

If the company fails to do so, then the bank reserves the right to sell the shares in the market to maintain the margin.

How Does it Affect Stock Valuation?

As we mentioned above, the pledging of shares is a common practice in companies.

A small percentage of promoter pledged shares should raise any red flags either. However, if you find that the company that you plan to invest in has a high percentage of promoter’s shares being pledged, then you need to consider the associated risks:

1. Higher Volatility in Stock Prices

If a company has a high percentage of promoter’s shares, then it usually witnesses high volatility in the market price of its shares. Here is why it happens:

Let’s continue the example mentioned above. Company A has availed of a loan of Rs.50 lakh by offering one lakh promoter’s shares as collateral. For the sake of this example, let’s assume that this is a high percentage of shares held by promoters. When the company took the loan, the share price was Rs.100.

Let’s say that after two weeks, some external situation forces the markets to crash and the stock price of Company A falls to Rs.70 per share. The bank immediately contacts the company and asks them to offer more shares as collateral to make up for the difference in price. If the company fails to do so, the ownership of the shares is transferred to the bank who can sell the shares to recover its losses. Assuming that the bank sells 50,000 shares at Rs.70. The remaining loan balance would be Rs.15 lakh and the market value of the securities available as collateral would be Rs.35 lakh. While this would help the bank recover its losses, it might trigger a selling spree due to panic.

Hence, the stock price would be highly volatile, and calculating its valuation can be difficult.

2. Skewed Management Decisions

If a company has a high percentage of promoter’s shares, then it might find it difficult to sustain profits since the borrowed funds are at a high cost. Hence, the company experiences pressure on future earnings.

3. Possible Loss of Control of the Company

There can be cases where the promoters lose the management control of the company. Let’s say that the promoters owned a 60% stake in the company and pledged half of it for a loan. If the company fails to repay and the lender decides to sell the pledged shares in the open market, then the promoters will be left with only a 30% stake in the company risking losing control over the company.

4. Possible Value Trap for Value Investors

Value investors try to look for stocks that are undervalued as compared to their intrinsic value. Many companies with a high percentage of promoter’s shares being pledged trade lower making them attractive to value investors.

However, as an investor, it is important to understand that such stocks don’t add a lot of value. While the interest outgo is usually in double-digits, the growth rates are much lower, and hence, even if the share prices seem undervalued, these stocks don’t add much value to the portfolio.

Remember, the pledging of promoter’s shares is not necessarily bad. Even if a company has a high percentage of promoter’s shares being pledged, if its operating cash flow is constantly increasing and the company has good prospects, it can be worth investing in.

Companies with strong management teams can use the funds raised by pledging the shares to expand the company’s operations and boost its revenue. While there is no rule of the thumb, a fundamentally strong company with less than 15% of the promoter’s shares pledged should not be considered a problem.

Summing Up

Remember, if you find a company with more than 15-20% of the promoter’s shares being pledged, then you must ensure that you assess its cash flow before making any investment decisions. Also, if a company has a high amount of pledged promoter shareholding, then stock price erosion is a distinct possibility. 

Along with the pledged amount, look for companies with good cash flow and a low debt-to-equity ratio. Also, look for any trend in the pledging of promoter’s shares. While a decreasing trend can be seen as a positive sign, an increasing trend can be dangerous. Keep the above-mentioned points in mind and carefully analyze all stocks before making a decision. 

Happy Investing!