More entities, more money

STOCKS

Demergers of companies offer opportunities to investors to create wealth. Here's why.

Company demergers are a very common feature nowadays. This helps companies to create individual profit-centres and investors in the company also benefit from the process, as there is a fresh valuation of the demerged entity.

However, the formation of a new entity also requires astute decision-making on the part of the investor because it has strong financial implications.

Investors also will have to take a call themselves on how to react to such situations. The factors that should be considered include:

EXTENT OF SEPARATION
First, the activities separated at the time of demerger is a critical factor. It is important to remember that the overall size of the business entity and the extent of the profits that it makes is one important factor that determines the pricing of the newly-listed shares.

Also, the future potential will determine the price impact after the demerger. This distinction is crucial because there could be basic arbitrage opportunities, immediately after listing. This is because the extent separation will give some idea about the listing of the new company.

For instance, when a company with a pre demerger price of Rs 250 separates an entity (Ratio 1:1) that trades at a price of Rs 55 and the original comes down to Rs 200 then it represents a 10 per cent gain for the investor immediately.

IDENTIFYING BENEFITS
The key role for the investor is to identify an entity where the strong or profitable business remains. And then, look for the company which has a future potential.

An example of this is say, a company is split into two additional companies, which are loss-making. This leads to a drop in the valuation of around 13 per cent. Also, if the profitability is only going to come after several years, a selling decision might be considered.

TRADING PRICE
One of the easiest give-aways when considering an an investment opportunity is the price at which the various entities are being traded. Based on these workings, there is a certain valuation given by the markets.

This can lead to some immediate gains for the investors where the price of the separate entities shoots up. Take for instance a company, which is trading at Rs 1,500 now. And after a demerger into two additional companies, it has a valuation that is 30 per cent higher.

This means good gains for the investor. Too high a rise and you should immediately opt for the sell option. It is not uncommon to find valuations touch dizzying heights after a demerger and the benefits have to be booked.

INVESTOR INTEREST
In many cases, it is just the investor interest in a particular counter that leads to a situation where the price of the share presents a selling opportunity for the investor. There is often high interest on a particular scrip, immediately after the demerger leading to a shooting up of the scrip.

Of course, such calls become difficult in a very depressed or buoyant market. However, following a thumb rule where the price of the scrip vis-à-vis actual valuation would give anyone a fair idea about the extent of overvaluation or undervaluation taking place.

FINANCIALS
It is best if you do not get swayed by the short-term disruptions. It is important to keep an eye on the financials to spot an opportunity. It is only a matter or time before valuations catch up with the prices in the market.

The writer is a certified financial planner