The ability to readily raise cash via equity is a key attraction of being listed on the stock market for most companies. Whilst standard placings are the most common method for most small to mid-tier companies, an alternative method exists in the form of a rights issue. A rights issue is fundamentally different in its structure, and is widely misunderstood by investors because it has the same end result; cash flows into the company. However, being able to understand how to adjust important figures such as earnings per share are crucial and this tutorial will seek to outline key points. This tutorial will use Kier Group's (LSE:KIE) recent rights issue as a primary example.
What is a Rights Issue?
A rights issue is a method of raising funds through giving existing shareholders the right to purchase new shares in the company at a discounted level. This number of purchase rights will be in a particular proportion. To crystallise this concept, let's look at Kier Group (LSE:KIE), a construction firm who sought to raise £340m through a rights issue in early 2015, in order to fund the acquisition of Mouchel Group. For reference, Kier traded at 1625p at the time of the rights issue and acquisition joint announcement.
In this instance the discounted level to purchase the rights at was 858p. The proportion was such that, for every 7 shares you currently hold, you have the right to purchase 5 new shares at that 858p level. Why are rights issues at a significant discount? It's to encourage investors to exercise their rights and it also acts as a basement level that the share price is unlikely to fall below pre-completion of the rights issue.
That discount has to be enticing because of this. Consider that the share price fell below the rights issue level before the rights issue is complete. In such a circumstance there is no incentive for investors to take up the rights issue, which could mean that the amount of money that needs to be raised, isn't. A fully underwritten rights issue guarantees that the amount that's intended to be raised, is raised, regardless of whether the existing investors themselves take up the entire offer. That is because there is a backstop institution that will purchase the slack.
Although the rights issue price may initially sound like a near 50% discount, the discount is not actually based off the share price at the time. It's based off something called the Theoretical Ex-Rights Price, or TERP. The TERP is the diluted value of the shares and it is the level that the share price should fall to the day after the extra shares are admitted to trading.
How to calculate the Theoretical Ex-Rights Price (TERP)
If you look at the image on the right, we can see that the closing price on the day prior to the shares being issued. This is a key number in calculating our TERP. We sometimes refer to this previous day closing price as the 'cum rights' price, but for simplicity I'll refer to it as the previous day closing price.
So what are we trying to find? All things be equal (i.e. assuming no company news and there is no market sentiment change at all), we are trying to find the 'new' share price post-rights issue. In other words, we are trying to find the 'correct' low point of the downward spike on the chart. In reality, there will be market sentiment and the relevant market index will move, so this price we calculate is only theoretical and will not match the actual spike low price.
To calculate the TERP we can apply a simple formula.
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Notice that the # of new/existing shares does not refer to the total shares, but more simply it's just the proportion factor that we discussed earlier. So now we have the TERP. All things being equal, Kier should have traded at circa 1324p on the day of the rights issue. So did that happen? Well, not exactly... and that's precisely why it's only theoretical. In the days/weeks after the rights issue has occurred, the share price is free to move in any direction and the TERP becomes relatively meaningless.
Under a Rights Issue, we need to adjust historic share-based valuation figures
This makes intuitive sense. The number of shares in issue have changed after the rights issue has taken place, and so has the share price. We therefore need to come up with a way to alter all the past valuation figures to fit the new share price so that we don't overestimate the dividend yield or underestimate the price-earnings ratio of the company. Of course, a rights issue would actually invalidate all other share-based valuation figures such as net asset value per share, unless you were to adjust them correctly.
How do we go about adjusting them? We generate an adjustment factor; the equation is fundamentally similar to that of TERP.
Again, let's apply this to the Kier scenario to prove up the concept.
Now it's very simple. All we have to do is take the historic EPS, dividend, NAV per share or any other share-based valuation figure and multiply it by this adjustment factor. For example, in 2014 Kier made 107.7p in underlying EPS. Making the mistake of not adjusting for the rights issue or following websites that have not updated, would lead you to conclude that, at the TERP of 1324p, Kier trades on a PE ratio of 12.3. In reality, the underlying EPS figure we should be using is now 107.7p x 0.799085 = 86.1p giving a PE ratio of 15.4.
However, this is not really credible for Kier for a simple reason. They have used the rights issue money to fund the acquisition of Mouchel, which will no doubt enhance earnings. So this use of the adjustment factor is more relevant for companies who undertake a rights issue without acquiring a company in the process.
What options does a shareholder have?
So far we have looked at a few core concepts to rights issues but we haven't actually looked at the mechanism for investors. Under a rights issue an investor has four options:
- Maintain their stake in the company by purchasing their full entitlement of rights; this requires an extra cash outlay from the investor as they are essentially purchasing new shares.
- Sell some or all of their rights to other investors. As long as a rights issue is not non-renounceable then these rights carry a value. Why? Because they give an investor the ability to purchase shares at a discount to the TERP.
- Sell some rights to fund the purchase of the remaining rights. This is called 'Tail-Swallowing'.
- Take up none of your rights. In this instance you would have your stake in the company diluted.
The TNPP is just the TERP minus the issue price. So in the case of Kier the TNPP = 1324p - 858p = 466p. This is the theoretical maximum price that an investor would be willing to pay for a single right as above this price they would make a loss. In reality, the nil paid rights are openly traded on the market during the rights issue process and their value will be swayed by the movements of the actual kier share price. if the Kier share price rises above the TERP to 1340p, then the Nil Paid Price (NPP) is no longer theoretical and the NPP = 1340 - 858 = 482p, for example.
A closer look at the Tail-Swallowing Process
Tail-swallowing is common because there is no additional cash outlay required from the holder. Let's base this off the Kier example again; the image we looked at is posted again for convenience. Say that an investor owns 2800 shares in Kier. They have the right to purchase a further 2000 shares under the 5-for-7 structure of the deal as 2800/7 * 5 = 2000.
How many of these 2000 rights do they need to sell to fund the purchase of the rest of the rights? We can use another basic formula.
Applying it to the Kier scenario.
Taking up 703 rights at the issue price of £8.58 (i.e. 858p) would cost £6,031.74. Selling one less right (1296) and purchasing one more right (704) would lead to a cash shortfall and a cash outlay from the investor would be required.