How to weigh up a rights issue

One of the main reasons for a company having its shares listed on a stock exchange is so that it can raise money by selling new ones to investors when it needs to. One way of raising money is to give existing shareholders the right to buy new shares at a discount to the existing share price in what is known as a rights issue.

Rights issues can easily confuse private investors. Some find it difficult to work out what they really mean for the value of their investments and whether it is in their best interests to buy more shares.

Often the mere mention of the words "rights issue" can send a shiver down shareholders' spines. That's because right issues are often associated with desperate, cash-strapped companies who need to shore up their finances. Shareholders like to keep hold of their share of the company's profits. Many think that any new shares that come on to the market might jeopardize that. This is not necessarily true as I shall explain shortly.

Entertainment One Group (LSE:ETO) has just announced a rights issue and there are rumours that struggling businesses such as Tesco might follow suit. But are rights issues really that bad? And how do you work out what they mean for your investment in a company?

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What is a rights issue?

A rights issue gives existing shareholders the right to buy new shares in a company in proportion to the size of their existing shareholding. So a 2 for 1 rights issue gives you the right to buy 2 new shares for each existing share that you own. To encourage shareholders to subscribe for new shares they will usually be offered at a sizeable discount to the current share price. As a rule of thumb, the more desperate the company is for cash, the bigger the discount. A rights issue will usually be underwritten by a stockbroker who will buy up any unused rights so that the company raises all the money it needs to.

So how do you weigh up the impact of a rights issue and what are your options?

Let's take Entertainment One's recently announced rights issue as a practical example. It is a 4 for 9 rights issue at a price of 153p compared with its current share price at the time of writing of 247p - a discount of 38%. So for every nine shares that you currently own you can buy four new ones at a price of 153p each.

The discounted price of the new shares means that after the new shares are paid for and start trading on the stock exchange the share price of the company will be lower. The first thing you need to do when you see the terms of a rights issue is calculate what is known as the theoretical ex rights price (TERP) as shown below.

9 existing shares at 247p£22.23
4 new shares at 153p£6.12
Value of 13 shares£28.35
Theoretical ex rights price£28.35/13 = 218p

To work out the TERP you take the second number in the rights issue (this is a 4 for 9 so we will use 9) and multiply that by the current share price. This gives you a value of an existing investment of 9 shares. You then take the number of new shares on offer - in this case 4 - and multiply that by the rights issue price. You then take both values and add them together and divided your answer by the new number of shares owned which will be 13.

The value of all our shares will be £28.35 or 218p each.

So the price of the shares should fall from 247p to 218p - the theoretical ex rights price.

As a shareholder you have a choice of three practical options with a rights issue:

Taking up your rights in full

If you decide to take up your rights in full, you will need to find £6.12 to buy four new ones for every nine that you already own. But does the maths stack up? Your nine existing shares will fall in value from 247p to 218p - a loss of 29p per share or £2.61 in total. However, you are also buying 4 shares for 153p that will have a value of 218p - a gain of 65p per share or £2.60 in total - meaning that you are not really any better or worse off which is how it should be.

A key factor in deciding whether or not you should take up your rights is what the company is using the new money for. Paying down debt can be a good idea as it will make your shareholding less risky which should be positive for its value.

Even better is if the cash can be put to good use invested in a profitable new business. Rights issues are often used to pay for restructuring a poorly performing part of a business. If this is the case then check out that the management's turnaround plan is credible. If it isn't then you may be throwing good money after bad.

Selling your rights

You might decide that you don't want to buy any more new shares. If so, then instead of letting the rights lapse before the pre-determined date, you can sell them or get your stockbroker to. If you do this, then you are selling the rights "nil paid" - because you haven't paid anything for them. The value of the rights in the Entertainment One example is 65p per share. It is simply the TERP less the rights issue price (218p less 153p). In practical terms, it is the profit available to shareholders from buying the shares at the rights issue price.

Selling some rights and taking up the rest

One of the practical problems involved with rights issues is when you hold the shares in an ISA. The problem comes when you have already put the maximum amount of cash into your plan for the year and so cannot put new money in to take up your rights. You may also be reluctant to sell some of your other investments in your ISA to raise the money you need.

Thankfully there is usually a way around this. You can sell some of your rights to raise cash to take up the remaining rights. To calculate the number of rights to sell, in order to buy the maximum number of shares at nil cost, you can perform the following calculation:

Rights x subscription price/TERP = 4 x 153p / 218p = 2.8 or 2 shares.

You need to round down to the nearest whole share. However, there is a slight problem if you are an Entertainment One shareholder with only 9 shares.

That's because selling 2 shares at 65p nil paid would only raise 130p which would leave you 23p short of the money needed to buy 1 new share at 153p. This means you could not buy any new shares at nil cost.

However, let's say you are more fortunate and own 1000 shares. With a 4 for 9 rights issue you would have the right to buy 444 new shares. Going back to the formula above, we would need to sell 311 nil paid rights at 65p to raise £202.15.

444 x 153p / 218p = 311

This will allow us to buy 132 new shares at 153p (£202.15/£1.53) with 19p of cash left over.

How to decide what to do

Let's look at the practical issues facing a shareholder in Entertainment One a little more closely. The company is using the money from the rights issue to buy 70% of the company which owns the very popular Peppa Pig television series and related merchandise that goes with it. What existing shareholders need to be comfortable with is whether this purchase will make them richer. This all boils down to whether profits from Peppa Pig can keep on growing and Entertainment One has not paid too much to get its hands on those profits.

One of the good things about rights issues is that the company has to issue a prospectus to its shareholders. This will contain lots of very useful information about the business, its future prospects and the risks that it faces. You should read this prospectus and keep hold of it for future reference. You can also find useful information from the news function in ShareScope and SharePad.

However, if you think that Entertainment One has a bright future and its share price will go up then taking up your rights in full will make you better off than if you don't. I'll show you why in the table below.

Let's say that you decide not to take up your rights and the share price goes up to 300p. As you can see, the value of your investment before and after the rights issue is almost identical at 2222p. If the shares go up to 300p, then your investment will be worth 2700p (or £27) and you will have made a gain of 478p.

BeforeValue
9 shares @ 247p2223p

After:
9 shares @ 218p1962p
4 rights sold @ 65p260p
Total investment value2222p

9 shares @ 300p

2700p
Gain/Loss478p

Now see how much money you would make if you had taken up your rights in full.

Taking up rights in fullValue
13 shares @ 300p3900p
Less:
9 shares @ 247p-2223p
Cost of 4 new shares @ 153p-612p
Gain/Loss1065p

The starting value of your investment is exactly the same at 2223p. But now you have 13 shares instead of 9. Taking into account that you have had to pay 612p for four new shares, you still end up making more than twice the amount of money if the share price goes to 300p compared with doing nothing.

Here you are reaping the benefits of paying just 153p for four of your shares. Your profit on these at 300p is a whopping 96%.

But what happens if the share price goes down to 175p instead?

Do nothingValue
9 shares @ 218p1962p
4 rights sold @ 65p260p
Total investment value2222p

9 shares @ 175p

1575p
Gain/Loss-647p

Take up rights

Value
13 shares @ 175p2275p
Less:
9 shares @ 247p-2223p
Cost of 4 new shares @ 153p-612p
Gain/Loss-560p

By taking up your rights your losses are smaller than if you had done nothing. The fact that you have four shares that only cost 153p each gives you a bit of downside protection compared with doing nothing. Only if the share price subsequently falls below the rights issue price of 153p will you be worse off by taking up your rights in full.

Are rights issues a buying signal?

Possibly. Share prices can fall in anticipation of a rights issue but may do well afterwards if it has placed the company on a firmer financial footing which allows it to recover. Alternatively, if the money raised in the rights issue is invested in a new business that subsequently makes a lot of money then you can end up making a tidy profit on your rights issue shares.

The caveat here is that the valuation of the shares in the rights issue are not horrendously expensive to start with. Companies with highly valued shares (known in the trade as highly-rated shares because they trade on a high multiple of profits) are often tempted to milk investors' current enthusiasm for them and offer the opportunity to own some more. Even with a discount, it is possible for shares in a rights issue to still be overvalued.

Shares with high valuations can only be justified if future profits grow rapidly. If those expected profits baked into the share price don't materialise then buying new shares in a rights issue, even at a discounted price, could end up costing you money.

Companies announcing rights issues may be worthy of further research to see if you can pick up a bargain.

Rights issues are often misunderstood. It has never ceased to amaze me how many times I have heard people - even professional investors - say that rights issues are bad because they are dilutive. By this they mean that the extra shares being issued water down -reduce - a shareholder's ownership stake in a business.

This is not true if you take up all your rights. The whole point of a rights issue is that it treats all existing shareholders fairly regardless of the size of their shareholding. In the case of Entertainment One above, every shareholder can buy four new shares for every nine already owned. If every shareholder takes up their rights then the existing ownership stakes are maintained. Your ownership stake will only go down - be diluted - if you do not take up your rights in full.

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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.