As COVID-19 devastates the economy, some industries have seen revenues fall 90% and are quickly running out of cash. More companies are reaching for a government bailout.
If you’re a shareholder, this undoubtedly makes you nervous. How much of your investment might you lose? Should you welcome the government stepping in?
What is a government bailout?
First the good news: a government bailout might stop the value of your investment in shares going to zero.
In a typical bankruptcy (i.e. without a bailout), a company’s assets are sold for cash. As a shareholder, you’re a part owner of this money. However, you probably won’t get paid. Most often, assets are sold at fire-sale prices, well below their fair value. The rules over who gets paid and when they get paid mean that bondholders and other creditors are paid first. Afterwards, the company might owe suppliers money for products, services or materials. Once these debts are covered, there is usually nothing left.
A government bailout might stop a company filing for bankruptcy.
The bailout may take the form of cash or a business loan. In other cases, the government might buy bonds. Or it could take part ownership – even a controlling stake – by buying shares.
What happens to share values?
As a shareholder, you need to know what kind of bailout you’re in for:
- If the bailout is in the form of a loan, you might check the free cash flow (in the company’s cash flow statement) and current assets to see whether the interest is easily covered. A company’s income statement reveals its current interest expenses.
- If the government is taking part ownership, you need to know how much of the company it is buying.
When the government takes part ownership
This form of government bailout can harm shareholders, especially in the short term.
Imagine you have half a glass of fruit squash. You top it up with water. Theoretically, you have more squash, but it’s weaker. The same thing happens with your shares: any new shares sold to the government dilute the ones you own. Each share now represents a smaller stake, making it worth less.
Thankfully, once the government has bought in, it is under heavy pressure to show taxpayers a profit. Realistically, that can only happen if the company performs well.
For example, in the 2008 financial crisis, the government bought stakes in major banks. A bank, like any public company, has the power to create new shares and sell them.
The Lloyds bailout was moderately successful. The government now only holds about 1–2% of the company. With dividends, it made a modest profit for the taxpayer. Shareholders managed to stay afloat.
The Royal Bank of Scotland (RBS) bailout, meanwhile, was objectively a disaster. The government took a majority stake, pumping in £45 billion. RBS showed nine years of consecutive losses and didn’t pay a dividend again until 2018. The government has admitted that its investment will probably never be recouped.
Warning: a government bailout may have strings attached
Some conditions imposed by the government during a bailout may make it harder for share values to recover. For example, a ban on stock buybacks could prevent share prices from recovering.
Stock buybacks have played a massive role in boosting valuations. Some companies use their free cash or even borrow cheap money to buy their own shares. With fewer shares on the market, prices go up, as do the reported earnings per share.
Sometimes, buying back shares is smart.
However, buying overvalued shares is hugely irresponsible.
Political battles could also hamper a full recovery. According to the Independent, the recent talk of airline bailouts has prompted more than 20 climate groups to act. The groups have written to Chancellor Rishi Sunak demanding that government bailouts be tied to new environmental regulations.
Do government bailouts work for shareholders?
Each case is different. In short, holding onto shares could be a gamble. If you want to bail out of a company that’s getting a government bailout, watch the headlines closely. If your company enjoys some good news, the stock markets may become temporarily optimistic. This will cause the share price to rise, giving you a chance to sell.
