31st May 2012
Equity shares or stocks are the only investment that comes to our mind when the stock market is doing well. However, there are other means like warrants which can help us reap benefits from rising stock markets. Warrants are not only the other way of participating in companies good performance but they are also more cost efficient in terms of overall returns.
In simple terms, a warrant is like an option issued by a company that gives the holder the right to buy stock from the company at a specified price within a certain designated time period. Generally speaking, warrants are issued by the company whose stock underlies the warrant and when an investor exercises a warrant, he or she buys stock from the company. A stock warrant is a way for a company to raise money through equity (stocks). A stock warrant is a smart way to own shares of a company because a warrant usually is offered at a price lower than that of a stock option. ^1
Like an option, a warrant does not represent actual ownership in the stock of the company and it is simply the right (but not the obligation) to buy shares at a certain price in the future.
The main difference between warrants and call options is that warrants are issued and guaranteed by the company, whereas options are exchange instruments and are not issued by the company. Also, the lifetime of a warrant is often measured in years, while the lifetime of a typical option is measured in months.
The most common reason for a company to issue warrants is to provide a "sweetener" for a bond or preferred stock offering. By adding the warrants, the company hopes to obtain better terms (lower rates) on the debt or preferred stock. Moreover, warrants represent a potential source of equity capital in the future and can thus offer a capital-raising option to companies that cannot, or prefer not to, issue more debt or preferred stock. ^ 2
Warrants are transferable, quoted certificates, and they tend to be more attractive for medium-term to long-term investment schemes. Tending to be high-risk, high-return investment tools that remain largely unexploited in investment strategies, warrants are also an attractive option for speculators and hedgers.
Transparency is very high with these investments and warrants offer a viable option for private investors as well. This is because the cost of a warrant is commonly low, and the initial investment needed to command a large amount of equity is actually quite small.
Let’s say for example warrants are issued by ABC Company. These specific warrant states, that in 2016 the warrant holders shall have the right to convert their warrants into equity for Rs 650 per share with current price being Rs 880 per share. These warrant trades very thinly and the cost was Rs 280.
Current EPS is Rs 20 and PE is 44. Now assuming that ABC would show an annual EPS growth of 35% the 2016 EPS for the company should be Rs 67. If the market were to discount that by 30 times (Expected PE in 2016) the stock would trade at Rs 2000 in the year 2016. Here comes the effect of the warrant:
*Net realizable return = net return/investment
*Return in case of warrants= 2000-650=1350
*Net return= Return-Investment
The above shows that investing in warrants can give higher returns in percentage terms because the amount initially invested is low compared to investing in stocks.
Disadvantages of investing in warrants
- Disadvantage and risk to the warrant investor is that the value of the certificate can drop to zero. If that were to happen before it is exercised, the warrant would lose any redemption value. ^3
- Finally, a holder of a warrant does not have any voting, shareholding or dividend rights. The investor can therefore have no say in the functioning of the company, even though he or she is affected by any decisions made.
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Disclaimers: Investments in equity are subject to market risks, please read the SEBI prescribed Combined Risk Disclosure Document prior to investing. Mutual Fund Investments are subject to market risks, please read the offer document carefully prior to investing. Our research should not be considered as an advertisement or advice, professional or otherwise. The investor is requested to take into consideration all the risk factors including their financial condition, suitability to risk return profile, and the like and take professional advice before investing. Derivatives are a sophisticated investment device. The investor is requested to take into consideration all the risk factors before actually trading in derivative contracts.