Theoretical Ex-Rights Price (TERP)

The Theoretical Ex-Rights Price (TERP) is the estimated market price of a company's shares immediately after a rights issue takes place. Think of it as a calculated benchmark, not a guaranteed trading price. When a company offers existing shareholders the right to buy new shares, usually at a discount, the total number of shares increases. This naturally affects the price of each individual share. The TERP provides a quick, unemotional calculation of what the new share price should theoretically be, assuming the only change to the company is the fresh cash received from the rights issue. It's a weighted average, blending the value of the old shares trading at their cum-rights price (price before the rights are factored out) with the value of the new shares being issued at a lower subscription price. In essence, it answers the question: “If we just account for the new shares and cash, what should the share price be tomorrow morning?”

In the world of investing, a rights issue can feel a bit like a pop quiz. Do you buy the new shares? Do you sell your rights? Do you do nothing? The TERP is your cheat sheet for the first part of that quiz. Its primary job is to help you understand and quantify the impact of dilution. When new shares are born, the value of your existing holding is spread over a larger number of total shares, which “dilutes” your ownership percentage and typically causes the share price to drop. The TERP gives you a solid reference point for this expected drop.

• It’s a Benchmark: By comparing the TERP to the old share price, you can see the theoretical price impact of the dilution.
• It Informs Your Decision: If the actual share price on the ex-rights day (the first day it trades without the rights attached) is significantly different from the TERP, it signals that the market is either more optimistic or pessimistic than the simple math would suggest.
• It Helps Value the “Right”: The difference between the old share price and the TERP gives you a rough idea of the value of each right you hold, helping you decide whether to exercise them or sell them.

Let's put on our math hats. Don't worry, this is simpler than it sounds and requires no advanced calculus, just some basic arithmetic.

To calculate the TERP, you need four key pieces of information:

• The total number of existing shares in the company.
• The current share price (the “cum-rights” price).
• The terms of the rights issue (e.g., a “1-for-5” issue means you can buy 1 new share for every 5 you own).
• The subscription price for the new shares.

The logic is to add the total value of the old shares to the cash coming in from the new shares, and then divide that by the new total number of shares. TERP = [ (Value of All Existing Shares) + (Proceeds from New Shares) ] / (New Total Number of Shares) Or, more formally: TERP = [ (No. of Old Shares x Cum-Rights Price) + (No. of New Shares x Subscription Price) ] / (No. of Old Shares + No. of New Shares)

Let's imagine “Castle Holdings PLC” wants to raise some money.

1. It currently has 10,000,000 shares outstanding.
2. The current market price (cum-rights) is $5.00 per share.
3. It announces a 1-for-4 rights issue at a subscription price of $4.00 per share.

Let's do the math step-by-step:

1. 1. Find the value of the existing shares:

10,000,000 shares x $5.00/share = $50,000,000

1. 2. Find the number and value of the new shares:

Number of new shares = 10,000,000 / 4 = 2,500,000 new shares.

  Proceeds from new shares = 2,500,000 shares x $4.00/share = **$10,000,000**
- **3. Find the new total value and total number of shares:**
  New total value = $50,000,000 (old) + $10,000,000 (new) = **$60,000,000**
  New total shares = 10,000,000 (old) + 2,500,000 (new) = **12,500,000** shares
- **4. Calculate the TERP:**
  TERP = $60,000,000 / 12,500,000 shares = **$4.80** per share.

So, the theoretical ex-rights price for Castle Holdings PLC is $4.80.

In a perfect world, the actual market price would open exactly at the TERP. But we don't live in a perfect world; we live in a market driven by humans. The actual ex-rights price often deviates from the TERP because the market is constantly pricing in new information and sentiment. Factors that cause the deviation include:

• The “Why”: The market’s judgment on why the company is raising money is critical. Is the cash for an exciting, high-return growth project? The market price might trade above the TERP. Is it to plug a hole in a sinking balance sheet? The price might fall below the TERP as investors get nervous.
• Market Sentiment: General market optimism or pessimism can pull even the best-laid plans up or down. A major political event or economic news can easily overshadow the mechanics of a rights issue.
• Take-up Rate: If it looks like not all shareholders will exercise their rights, it can create uncertainty about the success of the capital raise.

A value investor acknowledges the TERP as a useful, quick calculation but sees it for what it is: simple arithmetic. It tells you about price, not value. The real work for a value investor begins where the TERP calculation ends. The crucial questions are not about the math, but about the business:

• Is this rights issue creating or destroying value? The key is whether the company can invest this new capital and earn a return that is higher than its cost of capital. If it can, the rights issue is ultimately good for long-term owners, even if the price dips initially.
• What are the underlying business fundamentals? Does the company have a strong competitive moat? Is the management team skilled and honest? A rights issue from a well-run, dominant company is an opportunity. A rights issue from a struggling company could be a desperate cry for help.

Ultimately, the TERP is a signpost, not a destination. It gives you your bearings on the morning of the ex-rights day, but a value investor's focus remains fixed on the long-term value of the underlying business.