What it means
The first and most common use is stub equity. This happens after a leveraged recapitalisation, where a company borrows heavily and uses the cash to pay a large special dividend or buy back most of its shares.
The shares that remain are the stub, and they now represent a thinly capitalised, riskier slice of the business. Because the company has taken on a lot of debt, the stub is much more sensitive to changes in profit.
A small rise in earnings can lift the stub price sharply, and a small fall can nearly wipe it out. Investors treat it like a leveraged bet on the company, which is why stubs tend to be volatile.
The second use is a stub period, which is a partial accounting or valuation period. When a company is valued part-way through a year, analysts forecast only the remaining months and discount those cash flows, giving a stub-period cash flow.
In lending, a stub period is a short first or last interest period that does not match the normal schedule. The third use appears in trading, where a stub is a small remaining position or the leftover shares of a company after a spin-off.
A parent that has spun off a valuable division leaves behind a stub, and analysts value it by subtracting the value of the spin-off from the old price. Looking at the stub on its own can reveal whether the market is undervaluing the core business.
The key nuance is that a stub is defined by what has been removed. To value it, you need to know what was paid out, how much debt was added and what cash flows remain.
Anyone reading a document that mentions a stub should check whether it means equity, a time period or a trading remnant.
In practice
Real-world examples.
Example
A mature food company wants to return cash to owners without selling the business. It borrows heavily and pays a large special dividend, and the shares that remain trade at a fraction of their old price. The stub now carries most of the risk because the debt must be repaid first.
Example
A conglomerate spins off its software division to shareholders. Analysts subtract the value of the new software company from the old share price and conclude that the stub, the remaining industrial business, is valued at only a few times earnings. They write a report arguing that the stub is undervalued.
Example
An analyst values a company on 1 October using a discounted cash flow model. She forecasts the final three months of the year as a stub period and discounts them for a quarter of a year, then values later years in full. This avoids counting cash flow that has already been earned.
Formula
Calculation
Stub equity value per share = (equity value before - cash paid out to shareholders) / number of shares remaining
Suppose a company has 50,000,000 shares priced at $10, giving equity of $500,000,000. It borrows $400,000,000 and pays a special dividend of $8 per share, with the share count unchanged. The cash paid out is 50,000,000 x $8 = $400,000,000. The remaining equity is $500,000,000 - $400,000,000 = $100,000,000, so each stub share is worth $100,000,000 / 50,000,000 = $2.00. This assumes the total value of the business is unchanged by the recapitalisation.Case study
Seen in the real world.
Ironbridge Packaging is an illustrative, fictional listed company with a share price of $20 and 30,000,000 shares, giving equity of $600,000,000. Its board, supported by a private equity investor, agreed a recapitalisation: the company borrowed $450,000,000 and paid shareholders a special dividend of $15 per share.
After the payment the remaining shares, the stub, traded at about $5. Their price then swung sharply: when profit beat forecasts by 10%, the stub rose 40%, and when a customer was lost, it fell by a third.
The finance director explained to employees who held shares that the stub was now a leveraged instrument. The illustrative lesson is that a recapitalisation moves value into the owners' pockets, and leaves the remaining shares far more sensitive to the fortunes of the business.
Watch out
Common mistakes.
- Assuming a stub share price of $2 means the company is nearly worthless, when most of its value was paid out as a dividend.
- Valuing a stub without adding back the new debt, which overstates what the remaining shares are worth.
- Confusing a stub period with a stub equity, when one is a length of time and the other is a share.
Questions
People also ask.
What is stub equity?
It is the small piece of ownership that remains after a company has distributed most of its value or taken on large debt in a recapitalisation.
Why are stubs volatile?
The debt comes before the shareholders, so small changes in the value of the business cause large changes in the value of what is left for them.
What is a stub period in a valuation model?
It is the partial year from the valuation date to the end of the first reporting period, and the cash flows in it are scaled down to the fraction of the year that remains.
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