What is a Tracking Stock?
Companies offer tracking shares to permit valuation of a specific piece of their business. The parent company’s original shares are reclassified to reflect the performance of the rest of the business. In theory, the parent company does this to demonstrate that the two parts (parent and tracking) added together will reflect the true value of the company and be worth more than just the original shares before the tracking shares are created. Unlike common stocks, tracking shares don’t always represent ownership interest in the underlying company, and many times the holders of the shares are not privy to many of the voting rights and protections given to shareholders of the parent company.
Why are Tracking Stocks Enjoying Popularity?
They are popular with both companies and investors because they let the market judge the worth of a fast-growing segment of a company independently of its other lines of business. However, not everybody likes the concept of tracking stocks. Because the cash flow of the reclassified parent can be used to pay the liabilities of the business line being tracked (and vice versa), there may be a temptation for companies to practice accounting manipulations and obscure the real worth of the individual business lines.
Advantages of Tracking Stock to Company?
Some companies can raise capital more cheaply with a tracking stock. A company having difficulty raising capital might positively influence potential investors by using a tracking stock to demonstrate how the economic entity would look as a stand-alone company. This permits the investor to better see how his/her funds are being used. In addition, tracking shares are sometimes used as “currency” for acquisition. They tend to be pricier because investors are willing to pay more for the growth usually inherent in these stocks. There are numerous advantages to using a tracking stock instead of spinning off a business line to be its own company. First, losses incurred by the business line covered by the tracking stock can be applied to reduce taxes owed by the parent company. This would not be the case if the business line was spun off as a new company. Second, raising money from investors is generally easier because tracking stocks are still owned by a larger company with a stronger financial position (i.e. deep pockets). Typically, a spin-off would have to pay more for its capital because it would be smaller and on its own.
Are Tracking Stocks Good Investments for Shareholders?
In recent years, tracking stocks have not lived up to their “hype” and have lagged the performance of their peers and the market overall. A couple of reasons which may help explain why tracking stock performance has tended to lag:
- shareholders will not receive the big premiums that usually accompany corporate takeovers, and
- there may be a conflict of interest for company directors and shareholders in a possible acquisition of a company that provides similar products and/or services.
Like other financial investments, a tracking stock should be evaluated based on its own merits (e.g. growth, profitability, risk, etc.), not as an investment class. Normally, a tracking stock will not meet our strict investment criteria. For more information, contact Henssler Financial at 770-429-9166 or email@example.com.