What is tracking stock?

As fervent propagators of financial literacy, IIFL endeavors to explain essential concepts that new investors in the stocks. exchange should know about. One such concept is called tracking stock. In an attempt to help you learn more about tracking stock, let’s take a closer look at what is a tracking stock, why companies issue them, and what you should keep in mind before investing in them.

About tracking stock

Tracking stocks are similar to regular stocks – they are issued by a company, and traded at the relevant stock exchange . However, tracking stocks are usually issued by a parent company, not to represent the financial performance of the entire company, but rather just one of its specific divisions.

In other words, tracking stock is defined as a unique equity offering issued by a parent company, one that tracks the financial performance of a specific segment or division of the company. The parent company’s stock and the tracking stocks trade in the open market separately.

You can typically witness this being done by large and diversified companies, where they believe that one of their segments has the potential for better financial performance than the parent company. As a result, tracking stocks give investors exposure to a specific division of a larger company's business.

Example:

Let’s consider an example to understand the meaning of tracking stock. A large telecommunications company has an emerging cutting-edge mobile division that could prove to be profitable in the coming years. The telecom company might choose to issue separate tracking stocks for this particular division, to separate its performance from the rest of the company’s financial performance.

Below are a few essential points to note about tracking stocks:

• The dividends received by an investor from a tracking stock are dependent entirely on the financial performance of the particular division for which the tracking stocks are issued. They do not reflect the performance of the overall parent company.
• Any shareholders of tracking stock, still have equity in the shares of the parent company.
• The financial performance of the tracking stock division is separately reported. However, it remains bound to the parent company, from both a legal and a financial standpoint.

Benefits and risks of tracking stock

1. For Investors

Tracking stocks essentially offers investors an opportunity to invest only in a particular portion of a larger business. The stock of well-established conglomerates often shows limited appreciation potential, since they consist of multiple divisions across various business lines. Tracking stocks can give investors insight into, and access to only the most promising portion of the company.

At the same time, tracking stocks allow investors to participate in business segments that suit their risk tolerance. Nonetheless, investors should be mindful of the risks involved in trading a tracking stock in a case where the parent company is not well established. The parent company does not give up control of the tracking division's operations. Investors of such shares typically have limited to no voting rights. In an event of bankruptcy or insolvency of the parent company, creditors will have a claim on the tracking division’s assets.

2.For Companies

Companies raise capital by issuing tracking stocks. These proceeds are then used to pay up debt, fund other growth projects, or invest further within the tracking division. The activity of trading stocks lets a company gauge investor interest in specific segments of the business.

For example, a large-scale technology giant may choose to use tracking stocks to separate its VR segment. Investor interest in each division is now more easily measurable based on the performance of the tracking stocks. With the option of issuing tracking stocks, companies also eliminate the need for the creation of a separate business or legal entity for the tracked segment.

On the flip side, however, companies that issue tracking stocks may parse out the best-performing parts of their company. If the parent company underperforms financially, the high-growth segment associated with the tracking stock won't help in offsetting the poor performance.

Final word

Now that you have a better understanding of the tracking stock definition, you know that these are special forms of stock that represent a division of a company and not the entire company itself. As an investor, you should always evaluate the risks and the benefits of tracking stocks, against each other before purchasing company stock.