Pledging of shares is one of the options promoters consider to meet various financial needs like working capital requirements, to fund other ventures or acquisitions or even for personal needs. Pledging of shares is similar to pledging any valuable asset you own. In this article, learn about pledging shares, its working, impact on the stock valuation and more.
What Is Pledging of Shares?
Pledging of shares is an arrangement in which the promoters of a company use their shares as collateral to fulfil their financial requirements. While pledging shares, promoters still hold ownership in the company. However, the value of the collateral changes with fluctuations in the market value of the pledged shares.
The promoters must maintain the value of the collateral. The minimum collateral value is agreed upon in the contract. If the value of the pledged shares falls below the amount fixed in the agreement, it triggers a ‘margin call’. In such cases, the promoters must provide additional shares to the lender or pay cash to make up for the shortfall of the collateral.
Banks or lenders can also choose to sell the pledged shares in the open market if the borrower is unable to repay the collateral value or make up for the difference in the values. The pledged shares are lost if sold in the open market; this reduces the promoters’ shareholding and can also impact the stock value negatively.
How Does the Pledging of Shares Work?
The pledging of shares is similar to a loan. Banks or financial institutions offer loans on taking the promoter’s shares as collateral. The value of the pledged shares is decided by the lender and promoter as per the market value of the shares. According to that, they pen down an agreement. They can get a loan after a haircut deduction. According to the RBI, the loan-to-value ratio of 50% should be maintained.
What is a Haircut?
A haircut refers to a percent difference between an asset’s market value and the value that can be used as collateral.
For instance, if the market value of the asset is ₹1,000 and the collateral value is ₹500, the haircut deduction is 50%.
Pledging of shares is favourable in bull markets when the market is moving upwards. In the bear market, if the value of the shares drops, it can be a loss for the promoters.
Impact of Pledging Shares on Stock Valuation
While a small percentage of promoter pledged shares may not cause concern, a high proportion of pledged shares can introduce significant risks that affect a company’s stock valuation. It can result in:
- Highly volatile stock price
For example, consider Company A, which pledged a substantial portion of its promoter’s shares as collateral for a loan when the stock price was ₹100 per share. If an external event triggers a market crash, causing the stock price to plummet to ₹70 per share, the company might face margin calls from the lender.
The company may need to offer additional shares as collateral to compensate for the lower share value. Failure to do so can result in the lender taking ownership of the pledged shares and selling them to recover their losses. For instance, if the lender sells 50,000 shares at ₹70 each, the company can redeem from its losses but could initiate a selling trend in the market.
Consequently, the stock price becomes highly volatile, making it challenging to assess its true valuation accurately.
- Pressure on earnings
Companies with a large percentage of promoter’s shares pledged may experience financial pressure due to the cost of servicing the loans. High interest costs can affect profitability and potentially depress earnings.
- Loss of management control
Promoters who pledge a substantial portion of their shares risk losing management control if they cannot repay the loans. This scenario occurs when lenders sell the pledged shares, reducing promoter ownership.
- Market perception
Pledging shares can affect market perception and investor confidence. Investors often view high levels of pledged shares as a sign of financial stress or lack of confidence in the company’s prospects.
- Value trap for investors
Stocks with a high percentage of pledged shares may appear undervalued and attractive to value investors. However, the interest costs, combined with slower growth rates, may limit the actual value these stocks add to an investment portfolio.
Is Pledging of Shares Good or Bad?
Pledging shares has both advantages and disadvantages. On the positive side, it offers access to capital for various needs, enabling liquidity management without asset sales and facilitating strategic investments. A few promoters use the company’s shares to fund other ventures and simultaneously benefit from the dividends offered by the company.
However, the downside includes increased risk due to potential margin calls, negative market perceptions leading to stock price volatility, and the risk of losing control of the company if repayment is problematic. Therefore, the goodness or badness of share pledging lies in the purpose, management’s ability to handle it, and its alignment with long-term financial goals.
How To Find Out if the Company Has Pledged Shares?
Every promoter who pledges shares of a company reports it in their financial statements. You can find out whether a company has its shares pledged by looking into its quarterly earnings. You will get the percentage of promoter holding and the percentage of the pledged shares.
Conclusion
Pledging of shares can be a common practice in the share market for promoters. However, as an investor, you need to be aware of the pros and cons of investing in such companies. Ensure to talk to your financial advisor before investing. To invest in the stock market, you must have a Demat account. Open a Demat Account now on Angel One for free. Happy Investing!
FAQs
What are pledged shares?
Pledged shares means the shares that have been used as collateral for a loan. The promoter (borrower) holds ownership of the shares, but the lender has the right to sell the shares if the borrower defaults on the loan.
Why do promoters pledge shares?
Promoters pledge shares when they need money to fund a new venture, for working capital requirements of the company or for personal needs; they can pledge shares to banks or financial institutions that take shares as collateral.
Is pledging shares safe or risky for promoters?
Pledging shares can be a risky practice, especially during a bear market. When the market is down, the value of the collateral decreases, which can force promoters to pledge more shares or sell their shares at a loss. This can lead to a decrease in the company’s share price and voting rights and damage the company’s reputation.
What is unpledging of shares?
Unpledging of shares is the process of releasing pledged shares from the lender. Once the loan is repaid, the lender will release the pledged shares, which are added back to the shareholder’s Demat account.
