How to understand a rights issue

One of the main reasons for a company having its shares listed on the 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 in proportion to their existing shareholding at a discount to the existing share price, in what is known as a rights issue. 

Some investors find it difficult to work out what rights issues really mean for the value of their investments and whether it is in their best interest to buy more shares.

Often the mere mention of the words 'rights issue' can send a shiver down shareholders’ spines. That’s because rights issues are often associated with desperate, cash-strapped companies that need to shore up their finances. In recent weeks, companies such as Tullow Oil (TLW), Aston Martin Lagonda (AML) and Intu Properties (INTU) have been linked with imminent rights issues for this reason.

The fear of rights issues rests with the accepted view that shareholders like to keep hold of their share of the company’s profits. Some think that any new shares that come on to the market might jeopardise that. This is not true as rights issues are designed to avoid this scenario from coming to pass, as we shall see shortly.

But are all rights issues something that should scare investors? Or do they offer benefits that should be welcomed?

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 two-for-one rights issue gives you the right to buy two new shares for each existing share you own. 

To encourage shareholders to subscribe for new shares they will usually be offered at a 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.

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

Let’s look at Marks and Spencer’s (MKS) rights issue, announced on 22 May this year as a practical example. It was a one-for-five rights issue at a price of 185p. This was a 31.8 per cent discount to the closing share price of 271.2p at the end of the previous day. 

This meant that for every five shares that each M&S shareholder owned, they had the right to buy one new one at a price of 185p. The company wanted to issue 325.1m new shares to raise £601.3m to buy half of Ocado’s UK grocery business.

Now let’s look at what the implications of this rights issue for shareholders would have been at the time.

Calculating the theoretical ex-rights price (TERP)

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), which takes the effect of the new shares issued into account.

M&S theoretical ex-rights price (TERP)

Source: Investors Chronicle

To work out the TERP you first take the second number of the rights issue terms (this is a one-for-five so we will use five) and multiply that by the current share price. This gives you a value of an existing investment of five shares. 

You then take the number of new shares on offer – in this case one – and multiply that by the rights issue price. You then take both values and add them together and divide your answer by the new number of shares owned, which will be six.

The value of all our shares will be 1,541p or 256.8p each. This is the theoretical ex-rights price.

All other things being the same, the price of M&S shares should have fallen from 271.2p to 256.8p – the theoretical ex-rights price – to reflect the issue of the new cheaper shares.

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

• Take up your rights in full.
• Sell your rights.
• Sell some of your rights and take up some of them. This is sometimes referred to as tail swallowing.

Taking up your rights in full

If you decided to take up your rights in full, you needed to find 185p to buy one new share for every five that you already own. But do the maths stack up? Your five existing shares will theoretically fall in value from 271.2p to 256.8p – a loss of 14.4p per share, or 72p in total. 

However, you are also buying one new share for 185p that will have a theoretical value of 256.8p – a gain of 71.8p per share, which offsets the losses on your existing shares and means that you should not really be any better or worse off, which is how it is meant to be.

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

Even better is if the cash can be put to good use to invest 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 that management’s turnaround plan is credible and do-able. If it isn’t then you may be throwing good money after bad.

Rights issues are often used to fund very large acquisitions that significantly increase the size of a company. You need to be confident that an acquisition of this kind is based on sound principles and does not have the potential to cause a lot of pain later on as many have.

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 a specified date, you can sell them or get your stockbroker to sell them for you. 

If you do this, then you are selling the rights 'nil paid' – because you haven’t paid anything for them. These rights have a value to them before they lapse. It’s very easy to work out what they are worth. It is the difference between the TERP and the price of the rights. In the case of M&S it was 256.8p less 185p to give 71.8p. This is the same as the theoretical profit those shareholders who take up their rights make on the new shares that we calculated earlier.

Selling some rights and using some of them – tail swallowing

One of the practical problems involved with rights issues is that you may not have enough spare cash on hand to take up your rights. This might be the case when you hold the shares in an Isa and you have already put the maximum amount of cash into your plan for the year. 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 some cash so that you can buy some new shares. To calculate the number of rights to sell to buy the maximum number of shares at nil cost you can perform the following calculation:

Number of rights to sell = (Rights x subscription price)/TERP = (1x185p)/256.8p = 0.72 rights 

You need to round down to the nearest whole share in most circumstances. However, there is a slight problem if you are an M&S shareholder with only five shares. The calculation doesn’t make practical sense. You can’t sell 0.72 rights.

Selling one share at 71.8p nil paid would only raise 71.8p, which would leave you 113.2p short of the money needed to buy one new share at 185p. This means you could not buy any new shares at nil cost.

However, let’s say you are more fortunate and own 1,000 shares. With a one-for-five rights issue you would have the right to buy 200 new shares. Going back to the formula above which is telling us to sell 0.72 of our total rights to buy one new share. This means we would sell 144 nil-paid rights at 71.8p to raise £103.39.

Just to stop this getting too confusing, let’s recap. We are being told to sell 0.72 rights out of a total right of one new share for every five owned. With 1,000 shares, we have the right to buy 200 new shares, so we must sell 144 of our 200 rights (200 x0.72).

Total number of rights to sell = (Rights to sell/Total rights) x total number of rights

(0.72/1) x 200 = 144 rights

144  x 71.8p = £103.39

This will allow us to buy 55 new shares at 185p (£103.39/£1.85) each at a cost of £101.75 with £1.64 of cash left over.

How to decide what to do

Let’s look at the practical issues facing a shareholder in M&S a little more closely. The company used the money from the rights issue to buy 50 per cent of  Ocado’s UK business. What existing shareholders need to be comfortable with is whether this purchase will make them richer. This all boils down to whether profits from Ocado can grow meaningfully in the future and whether M&S has not paid too much to get its hands on those profits. I have serious doubts on both of these issues, but time will tell.

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. The information in it can come in very handy.

Rights issues can boost returns and provide some downside protection

However, if you thought back in May that M&S with Ocado had a bright future and its share price would go up then taking up your rights in full would have made you better off than if you did not. 

Let’s say that you decided not to take up your rights (and sold them) and suppose the M&S share price went up to 300p. As you can see, the value of your investment before and after the rights issue is almost identical at 1,356p. If the shares had gone up to 300p, then your investment would have been worth 1,500p and you will have made a gain of 145p.

Rights issue and profit from rising share price – selling rights

Source: Investors Chronicle

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

Rights issue and profit from rising share price – taking up rights

Source: Investors Chronicle

The starting value of your investment is exactly the same at 1,284p. But now you have six shares instead of five. Taking into account that you have had to pay 185p for one new share, you still end up making more than twice the amount of money if the share price had gone to 300p compared with not taking up your rights.

Here you are reaping the benefits of paying just 185p for each new share. Your profit on these at 300p would be a very handsome 62 per cent. This is an example of the turbocharging effect that rights issues can have on shareholder returns if everything goes well.

At the time of writing. M&S shares are 219p. What have been the implications for shareholders who have taken up their rights so far?

Rights issue losses from falling share price

By taking up your rights your losses are smaller than if you had done nothing and sold your rights. The fact that you have one extra share that only cost 185p each gives you a bit of downside protection compared with doing nothing. Only if the share price subsequently falls below 201.4p would you become worse off by taking up your rights in full.

Rights issues can therefore offer shareholders a couple of benefits. They can boost returns from a rising share price and provide a degree of downside protection compared with not taking up the rights. In most cases it seems that they should be viewed positively, unless of course the company is heading for big trouble.

Kier Group’s (KIE) rights issue flopped badly last year as investors deemed that its difficulties could not be solved with fresh money. This seems to have been proved to be the right call.

Restaurant Group’s (RTN) mammoth rights issue last year increased its number of shares in issue by 144 per cent. Many commentators – including me – think that its acquisition of Wagamama was expensive and a huge gamble. Shareholders were given a huge discount in a 13-for-nine rights issue at 108.5p, compared with a 251.8p share price the day before the rights issue was announced. The shares have fallen to 151p at the time of writing, but while those who took up their rights are in profit on their rights issue shares, those who sold their rights and held on to their shares would have been better off.

The TERP was 167.1p and the value of the nil-paid rights was 58.6p. Anyone selling their 13 rights would have pocketed 761.8p in proceeds before costs. They now have nine shares worth 1,362.6p at a price of 151.4p to give a total value of 2,124.4p

Anyone taking up their rights would now have 22 shares worth 3,330.8p, but would have had to fork out 1,410.5p to buy 13 new shares at 108.5p, giving a net value of 1,920.3p.

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 that 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 are often tempted to milk investors’ current enthusiasm for them and offer them 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.