In today’s article, we will discuss pledged shares, a very important terminology and its significance when investing in stock markets. Anyone with a solid grounding in share markets has an understanding of how pledged shares work and the role they play in stock valuation.
As is known, whenever a company is in need of funds for conducting its regular operations or expansion, among its several available options, including corporate bonds, equity capital, bank loans, the most prominent is offering the promoter’s shares as security for the loan – in common parlance called pledged shares. Usually, this approach is taken when all other options of raising funds are impossible. The reasons to observe the pledged shares of a company before raising investments in those are briefed below:
- Higher volatility
If the firm has a higher percentage of the promoter’s shares, it will normally face high volatility in the share market for its prices. The stock prices would be extremely volatile. Further making the calculation of its valuation very difficult.
- Skewed Management
Whenever a company shows a lofty percentage of the shares that belong to the promoter, it should be assumed as a rule of thumb that the situation might be tough to keep up profits since the leased funds are coming at a high cost. Therefore the company is bound to experience massive pressure on its future earnings.
- Potential Loss of Control
Several times it might happen that the promoters have lost the management control over the company. Suppose, if the promoters had owned a 60 per cent stake in the firm and had pledged for half of the sum for a loan. Now, if the institution is failing to make repayments and the moneylender is determined to sell the pledged shares, in that scenario, the promoters would only have a 30 per cent stake in the firm, thus risking their control over the management and functioning of the company.
- Unnecessary future troubles
Companies having a larger portion of pledged shares are usually a warning sign indicating poor cash flow and high debt. In this event, analyzing the cash flow statement is helpful to gauge the cash inflows and outflows as well as the amount of debt the company owes to the outsider. If not observed properly, these pledged shares have a high chance of inviting future unnecessary troubles
- Potential Value Trap
Most often, value investors search for stocks that are unrated in comparison to their innate value. Many firms having a higher percentage of the promoter’s shares are being pledged trade lower, thus making them attractive to value investors. This can end as a potential value trap for investors.
The above reason explains that it is crucial as an investor to understand that such stocks that don’t add a lot of value might lead the interest to outgo usually in double-digits, and the growth rates would then become lower. Consequently, even if the share prices seem undervalued, the stocks would not add much value to the investor portfolio.
If an investor considers making an investment and finds the records show poor financial statements in addition to heavy promoter pledging, it is a straight red flag. Somewhere around 5 to 10 percent of pledged shares are good to be managed with efficiency, but increased pledging becomes problematic. When pledged shares decrease over a period of time, it can be taken as a positive sign but an increase in pledged shares over time becomes quite dangerous for promoters and shareholders both. One must note that even stable companies can become victims if the pledging of shares does not reduce over time. Hence observing the company’s pledged shares is vital to making better-informed investment decisions.
