Although we generally prefer an enterprise value based approach, earnings and price earnings ratios remain an important and legitimate component of equity analysis and valuation. Earnings based analysis includes the earnings per share enhancement or dilutive effects of major transactions.
We discuss the value relevance of earnings enhancement or dilution arising from new capital bring raised and invested, with a focus on rights issues. In an earnings-based approach to analysis, it is important to correctly apply the rights issue adjustment factors to both historical and forecast earnings per share.
A price earnings ratio is simply the share price divided by earnings per share. Therefore, it follows that a share price is earnings per share multiplied by a price earnings ratio. In equity valuation, if you can get the right EPS and correct PE ratio you will find the appropriate stock price. More importantly, if you can predict how both EPS and the PE ratio will change, you will be able to predict changes in stock prices. Of course, this is all easier said than done, as there are multiple complex and interconnecting factors that determine these variables.
One element of earnings analysis is considering the EPS impact of major transactions, including the raising of new capital and its application in business combinations, other investments, or as part of a change in financing mix. In most cases the calculation of the EPS effect is not difficult – simply identify the impact of the transaction on forecast earnings and, potentially, the share count. However, where equity capital is raised through a rights issue, deriving the appropriate share count and EPS numbers gets more complicated. Adjustments to historical EPS and previous forecasts of EPS are necessary in order to obtain the correct picture of earnings enhancement or dilution.
The mechanics of rights issues
A rights issue is an offer to existing shareholders for them to subscribe for additional shares in proportion to their existing holding. The issue price is set at a significant discount to the current share price to encourage shareholders to invest, typically 20% to 40%, or even more. The rights to purchase shares at a discount are valuable and they may be sold to other investors. This happens after the ‘ex-rights’ date, when the original shares and the rights trade separately, and until the rights are exercised.
Rights issue timeline
Rights issue discount should not affect shareholder value
The grant of valuable rights to investors, and the issue price discount, does not itself represent a wealth transfer. The change in shareholder wealth depends on how the capital raised is used in the business, not on the rights issue price. Any ‘gain’ by subscribing for shares at below the prevailing share price (the cum-rights price) or by selling these rights, is offset by a reduction in share price after the rights issue (to the ex-rights price).
In theory the issue price discount does not matter in shareholder value terms. Nor should it matter in terms of earnings enhancement and dilution – as long as you make the correct adjustments.
A rights issue can be thought of as a combination of an issue at the full stock price and a scrip issue representing additional shares at zero consideration. The fall in share price following a rights issue is a result of this embedded scrip issue.
For example, assume a company announces a 1 for 5 rights issue with an issue price of 7 when the (cum-rights) share price is 10. Prior to this the company has 100m shares in issue. Therefore, 20m shares are issued at a price of 7 giving a total capital raised of 140m. When the shares go ex-rights, we would expect the share price to fall, but that this is offset by the separately traded value of the nil-paid rights.
The theoretical ex-rights price is the expected price after the rights issue, being the weighted average of the cum-rights price and lower issue price. The price of the nil paid rights1The nil paid rights are actually a call option and should be valued as such. Nevertheless, in most cases that value will be close to the difference between the rights issue price and the theoretical ex-rights price. (whilst separately traded) is the value of the right to purchase an additional share at the issue price which will be worth the ex-rights price.
Theoretical ex-rights price = 5/6 x 10 + 1/6 x 7 = 9.50
Value of nil paid rights (per existing share) = (9.5 – 7) / 5 = 0.50
This rights issue can be analysed into a scrip issue that would reduce the share price from 10.0 to 9.5, in this case a 1 for 19 scrip issue or 5.3m shares, followed by an issue of 14.7m shares at the ex-rights price of 9.50.2This analysis could be reversed such that the issue at full price is assumed to occur first followed by the scrip issue. This will give a different split of the full 20m shares although this does not impact the EPS adjustments or the resulting earnings dilution or enhancement. Nevertheless, the order of the analysis we use makes the subsequent calculations somewhat easier.
The above analysis changes as the stock price varies during the period until the shares go ex-rights, at which point the exact scrip element is fixed. It is at this point that the final EPS adjustment is calculated.
Rights issues and EPS
The EPS effect of a share issue depends on whether the issue is at the ‘full’ market price or for zero consideration. Considering a rights issue is a combination of these, the EPS effect similarly combines the two calculations.
- Issue at full market price: Where shares are issued (or repurchased) at their market value the share count for EPS purposes is a simple time weighted average of the shares outstanding during the period. Although generally referred to as an issue at full price, this also includes shares issued at below the current share price, but that were fully priced at some prior date when the commitment was made; for example, shares issued following the exercise of stock options or the conversion of convertibles.
- Issues for zero consideration: If the share count changes but no consideration is received or paid, a retrospective adjustment is applied such that all historical EPS metrics reflect the revised share count. This applies to scrip or bonus issues, share splits and, in the case of a reduced share count, share consolidations. The adjustment is to multiply any share count prior to the event by the following factor:
Scrip adjustment factor = Shares after / shares before
For example, in the case of a 2 for 1 stock split, the share count for each prior period (including the current period prior to the date of the split) is multiplied by 2. Consequently, all prior period EPS figures (and other per share metrics) are halved. Given that the share price will also halve because of the split, all multiples and ratios remain unchanged.
The same adjustment also applies to stock consolidations, except there is an increase in prior period EPS. However, there is one exception which is where a stock consolidation is combined with a special dividend to produce a synthetic share repurchase. We wrote about this, and the problem of data providers not being consistent in their adjustments, in our article ‘EPS growth: Demergers and special dividends’.
For rights issues the retrospective adjustment is made for the scrip element of that issue, as shown in the example above. However, the more common approach is to identify the adjustment by calculating a theoretical ex-rights price3The ex-rights price used is theoretical in the sense that it only allows for the scrip element of the rights issue. In addition, there will be the normal daily change in the share price that will affect the actual opening price on the day the shares first trade ex-rights. and applying the following adjustment factor to the share count prior to the date of the rights issue.
Rights issue adjustment factor = Actual cum-rights price / Theoretical ex-rights price
The factor is based on the actual closing cum-rights price on the last day prior to the stock going ex-rights.
Continuing with the example above, the adjustment factor for that rights issue is 10/9.5 = 1.053. The share count used for all prior period EPS and for the shares in issue in the current period prior to the issue date are increased by this factor. This is illustrated in the model below.
Forecast EPS and EPS analysis
In our experience the adjustments to historical EPS in respect of scrip issues and the scrip element of rights issues are reasonably well known by investors, even if not always consistently applied. However, investors should also adjust forecast EPS metrics to determine whether a rights issue is earnings dilutive or enhancing.
To establish the EPS effect of a rights issue you should:
- Calculate the rights issue adjustment factor and apply this to historical EPS and your (pre-rights issue) forecast EPS. Use the current share price as the cum-rights price in the adjustment until the shares go ex-rights, at which point fix the adjustment factor based on the last reported cum-rights price and change your financial statement forecasting model accordingly.
- Identify the earnings effect of the new capital. Increase earnings to reflect how the new capital is expected to be used and the resulting incremental earnings. For the current period remember this must take into account the period for which the new capital will be available.
- Calculate the new average share count for the forecast periods. Now add the effective additional shares issued at a full price. For the current period this should be a time apportioned number of additional shares. For the ‘2e’ period the new share count should be your prior forecast plus the full number of shares issued in the rights issue.
It is the first of these steps and the adjustment to prior forecasts that we think may be commonly missed by investors. The result is that the rights issue may appear to be more dilutive than is actually the case.
Here is the model we use to analyse the earnings effect when a rights issue is announced. The data shown is the same as we use in the example above. The highlighted section is the element that can easily be missed.
The Footnotes Analyst – Rights issue earnings model
Be careful when calculating PE ratios in your model
The above analysis is simply designed to determine whether a rights issue is expected to be dilutive or not. An alternative approach is to adjust your model in two stages. When the rights issue is announced add the additional shares that represent an issue at full price and adjust forecast earnings. At this stage do not make any adjustment in respect of the scrip element of the rights issue; the resulting enhancement or dilution will be the same as above. The second step is to apply the scrip factor on the day the shares go ex-rights, adjusting both historical and forecast EPS at this point.
The advantage of a two-step approach is it means that historical and current PE ratios can be based on an unadjusted cum-rights share price. When the shares go ex-rights so too will your EPS metrics. Using our approach above you will need to adjust the share price used in any PE ratio calculation up until the shares go ex-rights
PE ratio comparison and the earnings effect
A short cut method to determine whether a transaction is earnings enhancing or dilutive is to compare the pre-rights issue price earnings ratio of the company (the PE of the new equity capital) and the effective price-earnings ratio of the new investment. The PE ratio of the investment is simply the incremental earnings (annualised in the case of the current period) compared with the capital raised. It therefore depends on how the capital raised is used. If the ‘acquired’ investment PE ratio is lower than the current ‘equity consideration’ PE, the transaction will be earnings enhancing for the relevant period.
In a further short cut, if the capital raised is used to repay debt, the PE of this ‘investment’ is the reciprocal of the post-tax interest cost of that debt. Considering current developed market interest rates, for many companies raising equity to repay debt is EPS dilutive. However, this does not necessarily imply a negative value effect – it is important to consider the impact of such a change on value drivers and therefore the price earnings ratio.
Impact on the price earnings ratio
EPS changes resulting from a rights issue (or any other transaction) are only part of the story. While a higher (lower) EPS metric is undoubtedly on average associated with higher (lower) stock prices, the relationship only holds fully if ‘all other things are equal’, and a change or difference in EPS for a particular company is the sole driver of price. This is of course rarely the case; price earnings ratios vary enormously due to differences in value drivers, such as growth, risk and the need for ongoing capital investment. Any change in these value drivers because of a rights issue will almost certainly result in a change in the PE ratio.
Analyse potential changes to value drivers as well as the expected change in EPS
It is the importance of analysing value drivers that led us to provide our target multiple models, the equity multiple version of which is shown below (the enterprise value target multiple model can be found here).
In these 2-stage models we link deserved or target valuation multiples to key input value drivers comprising growth, future reinvestment (implied by a forecast incremental rate of return on investment), and risk in the form of a discount rate. It is these three key variables you need to consider when determining whether a change in an EPS forecast due to a rights issue (or indeed any other significant transaction or change in a business) will impact value.
The Footnotes Analyst target equity multiple model
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For example, if capital raised in a rights issue is used to reduce net debt, the resulting impact on EPS will generally be dilutive. However, the lower leverage (and the resulting reduced financial risk and equity beta) should result in a lower cost of equity and therefore a higher deserved price earnings ratio. This should partly or fully offset the EPS reduction, and the overall stock price effect should only depend on the economic value effect of the change in leverage.
In addition, if the change in leverage is not intended to be permanent and the resulting spare debt capacity will be used to fund further investment, the overall value effect will depend on the market’s view of the ability of management to find value enhancing investments. In the model above, this will result in changes to the growth and returns inputs. As we said above, there are multiple and complex interacting factors.
Our target multiple models are clearly simplistic, but they do illustrate very well how value drivers impact multiples and the importance of not just considering EPS changes in respect of major transactions.
EPS changes matter, but are often not the full story
Nevertheless, EPS and changes in EPS do matter. As illustrated by the chart below, higher EPS will invariably result in a higher share price. In addition, even if the change in EPS should, in theory, be offset by a change in PE ratio, in practice it may be that the market is overly focused on EPS itself and that this could irrationally be the main driver of stock prices. We don’t necessarily subscribe to this view and believe the market to be more efficient than this implies; however, in our experience, many investors take the opposite view and believe that EPS changes dominate.
FTSE 100 companies stock price versus EPS
Note: The slope of the regression line approximates the FTSE 100 aggregate PE ratio. We have forced the line through the origin in the chart, which tends to exaggerate the degree of correlation. Outliers also have an effect such that we don’t think one can rely on these statistics. Nevertheless, the objective of this chart is simply to illustrate that both EPS and the PE ratio play a part in determining a stock price.
Beyond EPS and PE ratios
While there is nothing intrinsically wrong with the analysis of EPS and price earnings ratios, we think that it can be difficult to apply in practice. Earnings incorporates many different aspects of performance, including both ongoing operating activities and the results (often fair value changes) of investments. Combining very different types of profit into one metric and then using this as a basis for valuation is not easy. Non-GAAP metrics can help, but these are also problematic, particularly where they give an incomplete picture of performance.
An alternative is to base your analysis around enterprise value. This facilitates a more disaggregated approach where, for example, the value effect of operating activities is separate from that of investments and other non-core operations. It also means that multiples are less impacted by leverage changes, which is one of the key challenges when using price earnings ratios. This is a particular problem with rights issues given the likely leverage implications.
For more about why we think an enterprise value approach is superior when using valuation multiples, see our article ‘Enterprise value: Our preference for valuation multiples’ and for DCF valuation see ’DCF valuation: Financial leverage and the debt tax shield’.
Insights for investors
- A rights issue is a combination of a scrip issue and an issue of shares at full market price. Scrip issues do not affect shareholder wealth, therefore the rights issue discount should not either.
- Be careful to adjust your EPS metrics, including forecasts, to allow for the scrip element of a rights issue, prior to determining whether the issue and investment of the new capital is earnings enhancing or dilutive.
- A change in EPS matters but don’t assume that this will result in a similar effect on the stock price. Also consider how the deserved price earnings ratio will be impacted and the likely reaction of other market participants.
- Earnings based analysis may not be the best approach considering that EPS combines many different aspects of performance, and price earnings ratios are a complex combination of several value drivers. Also consider using a more disaggregated enterprise value based approach.