Expansion of Business Activity and Impact on Share price
- Sales and profit are the main drivers of Shareholders wealth creation in the long-run. Expansion of business activity is very essential for survival and growth of business as well as shareholders wealth
- Expansion of business may be undertaken either by mode of merger/acquisition with another corporate entity or by making an addition to existing fixed assets of the company
- Expansion of business activity normally results in increased share prices due to higher sales and higher profits. Companies can carry out expansion either by :
- Internal accruals of existing business
- Borrowed fund
- Equity dilution
- A mix of all these options
- Companies which carry out expansion from internal accruals of existing business are the best ones to invest in. Expansion carried out solely by equity dilution results in lower per-share profit to existing shareholders. Expansion carried out solely by borrowed fund might result in lower profits due to interest expense and cash flow is also impacted due to repayment of borrowed fund via periodical installments. Mix of all these options might be suitable considering capital structure and other factors specific to the company
- Companies which are functioning at maximum capacity utilization and do not carry out expansion have less scope of superior shareholder wealth creation
- Gestation period is the time taken for fixed asset to be put to use in case of expansion. In certain industries which are complex by nature the actual time taken for completion of expansion activity from it's inception is substantial and can be anywhere from 2 to 5 years. In such cases the impact of expansion on sales and profits can take time to appear on financial statements and share price might not provide sufficient appreciation during gestation period
- It is normally advisable to invest in a company 6-12 months period prior to expected completion of expansion. So that investor is able to enjoy the benefit of share price appreciation in just the time when it is about to happen rather than waiting for long years.
- Sometimes expansion fails and there is decline in share price. Historically it is visible that expansion carried out by a large proportion of borrowed funds in regulated sector like Infrastructure have failed. Also expansion carried out in sectors where major technological disruptions are visible in near future have high failure rate. Sectors which are nearing end of life cycle and are slowing down also can have high failure. These type of sectors and companies should be avoided by investors at all cost.
- Factors like tax considerations, market size, consumer demand, government policies for the sector, market sentiment, technicals on chart of stock etc. shall be given due consideration before arriving at decision of investment in the stock
