THE EFFECT ON MARKET CAPITALISATION
The fact that South African companies have been allowed to repurchase their own shares as from 1 July 1999, has created new challenges for financial analysts as well as company accountants and auditors. For the financial analysts, it has introduced an additional complexity during the evaluation of company financial performance. The accuracy of these valuations is dependent on the manner in which repurchase activities are reported (in annual reports as well as by the JSE). Although nine years have passed since the inception of share repurchases by South African companies, it appears that inconsistent reporting on these activities (in annual reports as well as by the JSE) has led to the overstatement of the market capitalisation by companies participating in share repurchase activities (Bester, Hamman, Brummer, Wesson and Steyn-Bruwer, 2008).
The Companies Amendment Act of 1999 allows companies to acquire their own shares and also allows subsidiaries to acquire shares in their holding company (up to a maximum of 10% of the issued shares of the holding company). The own shares repurchased by the company are cancelled from issued share capital (and re-instated as authorised share capital), whereas shares purchased by a subsidiary are not cancelled but are treated as treasury shares (therefore deducted from share capital in the consolidated financial statements) (RSA, 1999). When shares are purchased by subsidiaries, the number of shares used in the calculation of financial ratios is different for the company and the group. For example, if a company has an issued number of shares of 100 and repurchases 8 of its own shares, while its subsidiary purchases 5 of the shares, the number of company shares is 92, while the number of group shares is 87. Share trusts (through which many employee share option schemes are conducted) need to be consolidated (SAICA, 2007: SIC-12), and therefore also need to be deducted (and represent treasury shares) when calculating the number of group shares. The difference between the number of shares of the company and the number of group shares may be material: in Network Healthcare Holdings and Group Five, the difference amounted to 50% and 35% (relative to the number of group shares) respectively in 2006.
The question therefore arises: which number of shares should be used when calculating financial ratios, such as earnings per share (EPS), headline earnings per share (HEPS), net asset value per share and market capitalisation? The consolidation principle is applied in the annual report, and therefore it is the number of group shares that represents the correct number of shares when referring to consolidated results (and net assets). Another viewpoint on the number of shares to be used, is the ring fencing principle (i.e. to evaluate each company on an individual basis without regard to the consolidation principles). The ring fencing principle is applied by the South African Revenue Services when calculating the tax payable of an entity. It is, however, not logical to use the ring fencing principle (i.e. use the number of company shares) when calculating financial ratios included in group statements or when referring to consolidated results (and net assets).
The use of the number of group shares for EPS and HEPS purposes, leads to a larger ratio (EPS and HEPS) than would have been the case if the number of company shares were used as the denominator, and would therefore be the preferred number of shares to be used by the company accountant. This is also in line with the relevant accounting requirements (SAICA, 2007:IAS 33; SAICA, 2007:CC 07/02). However, when calculating market capitalisation and net asset value, the opposite prevails: the use of the number of company shares leads to a larger market capitalisation and net asset value and could therefore be the preferred number of shares to be used by the company accountant. There is no accounting standard (or circular or interpretation) prescribing the number of shares to be used when calculating the market capitalisation, and net asset value per share and the calculation thereof is therefore at the discretion of the company accountant. Market capitalisation is a reflection of a company’s size and many stock market indexes, such as the JSE Top 40 and other market capitalisation based indexes, are compiled on a basis of market capitalisation. There might therefore be an incentive to state a high market capitalisation in order to qualify for more prestigious indexes.
Which number of shares (company or group) is used in practice when calculating market capitalisation? A database compiled by the Graduate School of Business of the University of Stellenbosch (USB) was used to ascertain on which number of shares companies (in their annual reports) and the JSE base their market capitalisation calculations. The sectors covered by the USB database exclude Mining, Financials, Development Capital and Alternative Exchange. Although this database covers all repurchases from 1999 to 2007, only data for the most complete recent calendar year (2006) for which all published annual reports are available, were used. The complete database of companies involved in share repurchase activities for the period 1999 to 2006 contained 127 companies (excluding companies delisted or suspended before they published a 2006 annual report). Of these 127 companies, only 62 chose to publish market capitalisation in their 2006 annual report (Bester et al, 2008).
It was found that 47 (therefore 75%) of the 62 companies participating in share repurchases and publishing market capitalisation in their annual reports used the number of company shares in their market capitalisation calculation. Only 15 of the 62 companies based their market capitalisation on the number of group shares. However, only 10 of the 15 companies correctly calculated their number of group shares. All errors related to treasury shares: either ignoring subsidiary repurchases and/or the consolidation of share trusts (Bester et al, 2008). There seems to be uncertainty on which number of shares to be used when calculating the market capitalisation in annual reports. The only accounting requirement referring to number of shares is the EPS standard and HEPS circular: both of these require the use of the number of group shares. Accounting guidance is therefore required regarding the number of shares to be used in the calculation of market capitalisation. Even in the event of relevant accounting guidance on the calculation of market capitalisation, South African (SA) companies need to apply the term “number of group shares” correctly in their annual reports. SA legislation differs from most overseas countries by requiring the cancellation of own shares purchased (most overseas countries do not require cancellation of what is treated as treasury shares) (Cassim, 2003: 144, 145, 151) and allowing subsidiaries and share trusts to acquire the shares of the holding company (subsidiary and share trust holdings are generally not permitted by overseas countries) (Bhana, 2006: 249). The overseas precedent of calculating the number of group shares can therefore not be applied pari passu by SA companies.
It was also found that the number of shares used by the JSE in calculating the market capitalisation corresponds to the number of company shares. (The number of shares used by the JSE was obtained from the McGregor BFA database: Product called Analyser.) Of the 127 companies involved in share repurchase activities, the repurchase activities of 112 companies (therefore 88% of the companies) included repurchases by subsidiaries and share trust consolidations. Assuming that the number of group shares is to be used when calculating market capitalisation, the market capitalisation reported by the JSE is therefore overstated for 88% of the companies participating in share repurchase activities. The overstated number of shares (and therefore overstated market capitalisation) relating to 33 companies represents an overstatement greater than 10%; 2 of these companies (Group Five and Network Healthcare Holdings) have a material overstatement of 35% and 50% respectively. The reason for the use of the number of company shares in the calculation of the JSE market capitalisation is mainly due to the current reporting mechanism on share repurchases: share trust holdings are not reported to the JSE, whereas subsidiary repurchases are reported but not taken into account for market capitalisation purposes (JSE, 2007). The JSE uses a ring fencing principle when calculating market capitalisation. SA differs from most overseas countries regarding the share repurchases through subsidiaries (and therefore also share trusts). It is suggested that the reporting of these repurchases needs to be taken into account by the JSE when calculating market capitalisation.
Share repurchases in SA, involving subsidiary repurchases and share trust consolidations, presents a unique challenge. These repurchases affect the number of group shares, which differs from the number of company shares in issue. Market capitalisation is based on the share price multiplied by the number of shares. No accounting guidance exists regarding which number (company or group) should be used in the market capitalisation calculation. 75% of SA companies involved in share repurchases and choosing to disclose market capitalisation, base it on the number of company shares. The JSE, when calculating market capitalisation (and also when compiling the Top 40 index and other market capitalisation based indexes) base it on the number of company shares.
The fact that there are two numbers of shares in issue, i.e. the company and the group number, needs to be acknowledged. The consolidation principle is applied in annual reports. Users of financial statements therefore assume that this principle is applied on a consistent basis. It is therefore suggested that companies, when disclosing market capitalisation, disclose market capitalisation based on the number of group shares. It appears that the majority of companies follow the precedent set by the JSE, and calculate their market capitalisation based on the number of company shares. Users of financial statements will therefore benefit from a dual disclosure of market capitalisation by companies: based on group as well as company number of shares. This will enable users to compare the figure to that of the JSE (i.e. based on number of company shares) and to ascertain the true market capitalisation (i.e. based on number of group shares). If the JSE decides not to change the current reporting mechanism, it needs to communicate to stakeholders that a ring fencing principle is applied when calculating market capitalisation. This, however, leads to the overstatement of market capitalisation of companies involved in share repurchases via subsidiaries and share trusts.
Accounting standardisation (in the form of a standard, an interpretation or circular) is needed on the reporting of market capitalisation by South African companies.
Please refer to the online version of this article for references.
Prof. Willie Hamman CA(SA), BCom, DBA, and Nicolene Wesson CA(SA), M Com (Tax).