Rights issuances can be a tricky thing to evaluate as personal investors. While the apparent dilution of both the proportionate ownership that an investor holders over a company, as well the reduced price of the stock from the implied discount are enough to make one think twice about how it is that the company fits in their investment portfolio, there are a few other implications that add some depth to our analysis. Specifically, by taking at look at how it is that the company is benefiting from this sort of transaction, it is easier to make a tangible long-term investment decision based on the fundamental implications of the offering, rather than the short term adjustment that comes with the initial issuance.
The best way to see the benefits that a company realizes through a rights issuance is by using an example. Imagine a company that trades publicly for $1.40/share, and offers a 1-for-4 (holders of 4 shares receive 1 rights offering) that can be executed for $1.20/share. This will immediately dilute out the price of the company’s shares by a couple of cents (2-8 cents depending on volume of shares outstanding), and will raise equity financing for the company to put on its balance sheet for usage.
In doing so, the company will be increasing its equity aspect of its balance sheet, and making a potential adjustment to its value/share recorded. In this situation, if the company have previously issued its equity at $1/share the year before, this new rights issuance will actually increase its value/share of equity recorded on its balance sheet. While the issuance is not likely to have as large an impact on the book value as it does on the market value, it is important to recognize the implications realized by such a transaction.
As a result of a rights issuing the increases the book value of a company shares, the company’s Debt-to-Equity ratio (an extremely important measure for a company’s cost of capital) will shift to demonstrate a lower amount of leverage risk. Even though the company’s interest coverage rate (which shows its ability to continue making payments on its existing debts) remains the same, its balance sheet leverage declines, which might create an illusion of safety to an inexperienced investor.
From there, because of the way in which the rights issuance then adds cash to the company’s balance sheet, basic solvency ratios will be further improved, which again tends to increase the attractiveness of an investment opportunity by demonstrating safety. The end result is a situation where the improvements in a company’s balance sheet , as a result of a rights issuance, might just be enough to drive the share prices of a stock up, despite the dilutive impacts of the issuance.
So how is it that we can tell whether or not a rights issuance is going to improve the long-term integrity of a company? We look for the reason of the issuance. If the company is simply looking to put cash on its balance sheet, or make an acquisition, it might not necessarily be that this issuance is a positive sign. However, if the issuance raises funds to be invested into an expansion, and appealing project, or the reduction of the company’s debt load, then we might be seeing indications of an improved financial situation, and longer term feasibility.
