Pledging of Shares by Promoters and how it impacts Stock Valuation

[Last Update : 31-May-2020]
Did you know that more than 90% of listed companies in India have pledged shares? Are you aware of the risks associated with share pledging? How much share pledging is OK? Is share pledging also good for the company? From where can you find the pledged shares percentage?... Read on...

Share pledging by promoters is quite common, and it is important to understand many aspects regarding pledging of shares and take an informed decision before deciding to buy a stock.

Who are promoters of a company?

A corporate promoter is a firm or person who does the preliminary work incidental to the formation of a company, including its promotion, incorporation, and flotation, and solicits people to invest money in the company, usually when it is being formed. A promoter usually holds a good chunk of shares of the company in the initial stages. In India, promoters are also the majority shareholder group that manages the day-to-day affairs of a company.

How are promoters compensated?

Often, promoters are paid in company stock, or free entrance into the investing activity. A more standard fee for service structure may also be used to dictate the level of compensation.

What is Share Pledging?

When a company needs money to fund its running or expansion, very often, promoters of listed companies may pledge all or some of their shares with lenders. It means that these shares are offered as collateral to banks in exchange for loans. This is just like you keep gold as a collateral for taking gold loan, or your house as a collateral for taking home loans. 

This is one of the many sources of borrowing money, especially in a market with tight liquidity conditions - where other sources of borrowing may seem tough, or working capital rotation may be facing crunch. As an example, in a rising interest rate scenario, promoters often use shares owned by them as collateral for getting relatively cheaper loans. If the promoters are looking forward to pledging their shares, then it effectively means that all the other options of raising fund have been closed.

Is pledging of shares common?

Pledging of shares is quite common in companies where promoter holding is high. In general, there is nothing bad in pledging of shares to get loan and take the company forward. Just like, there is nothing bad in taking a car loan to buy a car, or home loan to buy your dream house. 

Who owns the 'pledged' shares?

While pledging shares, ownership of the shares is retained by the promoters. However, if the majority owner in your company has pledged a size-able chunk of his or her equity, it could trigger a volatile price movement in a falling market. We will talk about the associated risks later.

How much loan is available on pledged shares?

The loans that banks provide on pledged shares typically have a tenure of one to three years and carry a margin requirement of approximately two or three times. This means that the promoters have to keep shares worth 2-3 times the money they have borrowed. Now, depending on the price of the share, the collateral value can keep changing.

Risks associated with high pledging %

Though pledging in small % is quite common, there are many risks associated with high percentage of pledged shares by promoters. Some of them are listed below, though not in any specific order of risk:

1/ Higher Stock Volatility

Shares of companies with high pledging of promoter holding tend to witness higher volatility. Even the Indian federal bank (The Reserve Bank of India) has been flagging a concern over pledged shares. As a result, investors need to look at pledging of shares by promoters before buying stocks.

Higher the pledging, greater could be the risk of volatility in the company’s share price. This is because, as share prices fall, the overall value of the pledged collateral falls. This would put pressure on the promoter to produce more assets as collateral. Sometimes, the lender may also be forced to sell some of the shares to ensure that the loan does not turn into a bad loan. If the promoter is unable to meet obligations of borrowing, the ownership of shares is transferred to the lender, who may then sell it to recover loans. This leads to unwanted panic selling and volatility in the stock.
High pledging, thus, is not good for the promoter or the investor.

2/ Higher Pressure on Profits

On the business front, such companies may find it tough to maintain margins on their products and services, as most of the borrowing through pledging of shares is at a higher cost. This leads to pressure on future earnings and EPS.

3/ Risk of Management Control

In certain cases, the promoters may also end up losing management control of the company, if they are unable to repay, and the lender sells the pledged shares in the open market. 
Examples:
1/ State Bank of India in April 2013 sold shares of United Spirits and Mangalore Chemicals and Fertilisers that were pledged to them by Vijay Mallya against money lent to Kingfisher Airlines. The bank moved to do so after the airlines failed to repay its loan.
2/ In 2020, Yes Bank acquired 24% stake in Dish TV via invocation of 44 Crore pledged shares. Dish TV promoters owned 54.56% stake in the company, out of which over 93% was pledged with the lenders. YES Bank, sources say, had the biggest exposure. After the invocation of shares, Dish TV promoters are left with just over 30% stake in the company.

4/ Value Investors may fall in Valuation trap

Valuation Trap is something that investors may easily fall into when it comes to these companies. A number of these companies are trading lower as a result of a decline in their share prices - thus making the prices look attractive to a value investor. But these companies may not be adding much value to their equity shareholders. While their interest outgo would be in double digit, their growth may be in single digit and therefore while their share prices may appear to be lower and available at cheaper prices, they may not bring value to the shareholders.

How many companies have pledged shares?

In India, out of the over 5000 listed companies, promoters of 4274 companies had pledged all or some of their shares, according to an analysis by Securities and Exchange Board of India. Of these, promoters of 286 companies had pledged more than 50% of their shareholding. Nearly 90% of these companies belong to the small-cap category. The numbers obviously keep changing depending on market conditions.

How is the Risk Assessment done for Share Pledging?

Risk is calculated on the basis of the amount of pledged shares as a percentage of the total shareholding. When the shares pledged exceed 50% of the total shares of the company, the company falls in the high risk category. Companies fall into the medium risk category when the pledging is of the tune of 25-50% of promoter shares.

Pledging of shares is a sign of poor cash flow, high-debt company, with an inability to meet the short-term requirements. A decreasing pledging of shares over time is a good sign for the investors, and indicates low risk. On the other hand, an increasing pledging of shares can be dangerous for both promoters and shareholders. Even quality companies can become a victim if the pledging of shares is not reduced over time.

How to find the % of pledged shares by promoters for a company?

1. At National Stock Exchange Website

Follow these steps to find the percentage of pledged shares for any company for NSE.

1/ Go to NSE Website.

2/ Search for your Stock.

3/ Click on the Company Information tab.

4/ Then click on Market Tracker.

5/ Then Click on Shareholding Pattern.

In that page you can see the Number of Shares pledged or otherwise encumbered and also its percentage to the total no. of shares.

2. At Bombay Stock Exchange (BSE)

BSE has a much simpler mechanism to find out the pledged shares for any company:

1/ Just click on Shareholder Pledging Page. This is a dedicated page to find your Shareholder Pledging.

You will get a list of all companies whose shares are pledged along with their % holding. You can even search for a specific company and its shareholder pledging.

Example of Pledged Shares %

Below screenshot is taken from the BSE Website to find out the pledged shares for Tata Steel, as an example. It shows the % pledged shares for Tata Steel as 10.79%, which is just fair - as long as it is not trending upwards.

Is pledging of shares always bad?

Not really. 

Pledging of shares is not always bad for companies. You can understand this by relating with your personal loans. For example, taking an educational loan, car loan, house loan is not a big issue, if you have a steady income or an amazing future earning prospects.

Similarly, if the company has an increasing operating cash flow and good future prospects, then pledging of shares is not a big concern for them. Many times, pledging of shares helps in the expansion of the company or to carry out new projects which result in increased revenue in the future. Moreover, 5-10% pledging of shares in fundamentally healthy companies should not be considered as a problem.

Summary

While pledging of shares is quite common, especially for small-cap and mid-cap companies, any pledging over 25-30% should raise alarm bells, and above 50% should raise serious concerns about the cash flow of the company. Companies with high amount of pledged promoter shareholding are susceptible to erosion in stock prices. Look for, and go with companies that have good cash flow and have low debt-to-equity ratio. If the pledging is less, up to one-third of the promoters holding and has been done for purposes linked to core business, then there is not much of an issue. 

Along with the current holding, look for the trend of shareholder pledging. A decreasing pledging of shares over time is a good sign for the investors. On the other hand, an increasing pledging of shares can be dangerous for both promoters and shareholders. Even quality companies can become a victim if the pledging of shares is not reduced over time. 

Keep your eyes and ears open. One of the lessons to always remember, and as highlighted int he book, The Autobiography Of A Stock is that - One bad investment can ruin your 10 good investments. 

If you are careful, then you are in a wonderful place called Stock Market.

May 2020 : Revision 1 : Dish TV share pledging example included
Feb 2019 : Original Revision

Regards

Manoj Arora

Official Website