Monday, June 28, 2010

Is a rights issue good for shareholders / Should I participate in a rights issue?

One way that companies raise capital is by issuing shares through a rights offering. Some shareholders see rights issues as a "gift" from the company, because the exercise price is usually below the market price of the shares in the market. They view a rights issue as the company giving them a special "by invitation only" opportunity to buy shares a discount to its market price. Others see a rights issue as a sign that the company's investment merits are deteriorating because the company is either being forced to adopt a lower-debt funding structure that reduces the shareholder's return on equity, and/or is becoming more capital intensive.

This post explains how both perspectives can be valid depending on the conditions surrounding the way the market views the company.

Case Study: an example of a rights issue and how it affects shareholders

Here's a simple, but representative, example that illustrates the mechanics behind a rights issue:

You buy one (1) share of a company with the following financial structure:
Total shares issued: 1,000
Shareholder's equity: $2,000 ($2 per share)
Earnings: $1,000 ($1 per share; ROE=50%)
Market price: $10 per share (PE ratio of 10; PB ratio of 5)

The next day, the company makes a 1:1 rights offer with an exercise price of $5 per new share. This gives the company the following financial structure immediately after the offer is exercised:
Total shares issued: 2,000
Shareholder's equity: $7,000 ($3.50 per share)
Earnings: $1,000 ($0.50 per share; ROE=14.3%)

Does it make sense for you as a shareholder to participate in the rights offer? If your primary concern is in maintaining your voting power, then you need to subscribe to the rights issue in order not to have your stake diluted. Otherwise you will end up owning a smaller percentage of the company.

However if your primary concern is the value of your stock holdings, then it depends on how the market values the company: whether the market values the company as a multiple of its earnings, or as a multiple of its book value.
  • If the market values the company as a multiple of its book value, then a rights issues is beneficial to an existing shareholder only if the exercise price of the rights shares are above the Shareholder's equity per share of the original shares.

  • If the market values the company as a multiple of its earnings, then a rights issue is beneficial to an existing shareholder only if the company can employ the additional capital at an ROE similar or greater than the ROE enjoyed on the company's existing shareholder's equity.

Here's why:

(A) Companies that are valued by their PE ratio.

In the best case scenario, the capital raised can be used with a ROE of 50% (the original ROE achieved by the company), then the company will end up earning $3,500 or $1.75 a share, and can be valued at $17.50 if the PE ratio remains at 10. If the company cannot put the new capital to such productive use, then the price of the shares should be lower because the earnings are lower.

Assuming this best case scenario, how then would a shareholder fare? A shareholder which bought 1 share originally at $10 (which he could have sold for $10), would have put in an additional $5 to subscribe to the second share. By contributing $5 out of his/her pocket, he now has 2 shares each worth $17.50, for a total of $35. The additional $5 contributed has resulted in a gain of $25. What has effectively happened is that the company has offered the opportunity to (1) invest $5 in a venture that has a ROE of 50%, and (2) benefit from the market's propensity to capitalize those additional earnings at a certain PE ratio. The shareholder has gain of $35-$10 - $5 = $20 ($35 of shares after the issue, $10 for the initial share purchase, and $5 for the rights exercise price)

Businesses that are lumpy step functions (like property developers) where there is a need for huge amounts of funds for each "project" can end up raising rights issues often. While they can try to keep retained earnings until they reach the critical mass needed for a project, many avoid doing this because during the interim years, the retained earnings just sitting there will be a drag on ROE and result in unhappy shareholders.

However in the worst case scenario, the company needs the additional funds just to continue operating as it is. Then the rights issue would be extremely bad for all shareholders. In this scenario, the company would continue earing $1,000, or $0.50 per share (since there are now 2,000 shares after the rights issue, instead of the the original 1,000 shares). The fair value price of the share would then be $5, assuming the PE ratio of 10 is maintained.

An investor would then be worse off. He originally paid $10 for one share. Then had to to pay $5 for the rights issue. In effect, he paid $15 for 2 shares, and the 2 shares are now worth $10 in total. A loss of $5 for the shareholder. In reality, if the ROE of the business dropped, the fair value of the company in PE ratio terms would also drop, which would further reduce the value of the shares. This is a simple mathematical relationship in the Discounted (Extractable) Future Earnings model for valuing any asset.

So in summary, whether or not you are financially better off depends on the ROE at which the company can employ the new capital being raised:
  • (a) if the company is raising funds for a new venture, then the funds raised had better earn returns that justify the current share price.

  • (b) if the company is raising funds to continue operations, because it cannot access debt, then your ROE is dropping and the fundamental investment merits of the company have changed.

(B) Companies that are valued based on their book value.
The amount of gain for a non-participating shareholder depends largely on how much higher the rights exercise price is to the book value per share of the original shares.

In the best case scenario where shares are issued at a price higher than current book value per share, you would have benefited even if you had not participated in the rights offering. Let's see how this works: your original share would now be worth $17.50 each and you would have a gain of $7.50. What has effectively happened is that you've gotten a free ride, because the rights shares buyers are effectively subsidizing you. Buying the shares on the open market, you paid $10 each share which had $2 of underlying shareholder equity, without actually injecting any equity into the company. Whereas the "buyers of the new rights shares" are injecting $5 for every new rights share they are being given. This $5 they have injected will increase the value of your "original shares". In other words, there is new additional shareholder's equity for your shares, that is being paid for by the new buyers.

But if the company has issued the rights at an exercise price of $2 (the book value of the original shares prior to the rights issue), the company would have $4,000 in shareholder's equity. There would be no gain for you in book value per share terms. So the market value of your stock holdings would be unchanged.

In the worst case scenario, the company has issued the rights at an exercise price of $1 (below the book value of the original shares prior to the rights issue), the company would have $3,000 in shareholders' equity. The book value per share would have dropped to $1.50 per share, and the market value of your existing shares would be diminished. In this case, it pays to subscribe to the rights, since the premium of the market value of your new shares over their exercise price would counter the loss in market value of your current shares. Whether or not this completely compensates for the drop in value of your existing shares depends on how far below the book value the new shares are issued at.

So in summary, whether you benefit depends on whether the shares are issued at an exercise price equals to the book value of the current shares, or if it is greater/less than it. If it is greater, than you may benefit even if you don't subscribe to the shares. If it is less, then you may need to subscribe to the shares just to minimize the losses in the market value of your existing shares.

Short-term trading opportunities when a rights issue occurs and trades on the secondary market

In the short term after a rights issue is announced, the immediate question that strikes many investors is: is there money being left on the table, when a company is selling new rights shares at less than its market price? Strictly speaking the answer is no, because the current share price is simply a reflection of the returns on the capital /book value already in the company. The rights issue will have changed this calculus, because the key question going forward is what is the ROE on the new capital / the new book value per share after the rights issue.

However this line of thought is sometimes the reason why the existing/new shares may continue trading at their prevailing prices. (In other words, the market can't figure out the "correct share price" after the rights-issue) This can create a short-term windfall for existing shareholders, because the rights may trade at over-valued prices. When this occurs, shareholders who subscribe to the rights can sell the rights. Likewise, the market may clear at a a too-low "post-rights-issue" price, and the rights trade at a unfairly low price. This creates a buying opportunity for new investors to take an ownership stake in the company at a discounted price to the market.

The key in both situations is that you must have a clear idea of how the market values the company over the long run, and whether the rights exercise price creates a beneficial or detrimental situation for you as an existing shareholder (see our earlier analysis). That will allow you to figure out the price that the shares would likely trade over the longer term after the rights-issue, and allow you to see if a mispricing has occurred which you can take advantage of. Of course, be aware that the mispricing may continue for quite a while, even after the rights issue exercies, because it takes a while for the company to actually deploy the capital and earn the return which you think it should be earning.