What Is a Theoretical Ex-Rights Price – TERP?

What Is a Theoretical Ex-Rights Price – TERP?

Let me explain what a theoretical ex-rights price, or TERP, really is. It's the market price that a stock should theoretically reach right after a new rights issue. Companies often turn to rights issuances to sell more shares to their existing shareholders, and they do this at a discounted rate. This move directly affects the stock price because it boosts the total number of shares out there.

Theoretical Ex-Rights Price Explained

You need to understand that a theoretical ex-rights price comes into play with stocks issued via a rights offering. These offerings are usually just for current shareholders and last only a short period, say around 30 days. In them, shareholders get the option to buy a certain number of additional shares at a preset discounted price, proportional to what they already own. The main aim here is to pull in more capital while prioritizing those current shareholders.

These stock rights offerings can draw a lot of attention from investors and traders because they open up potential arbitrage plays during the offering window. Overall, this period can throw a wrench into efficient market trading by injecting uncertainty into the stock's price.

Managers use stock rights offerings as a straightforward way to raise capital through equity. They might opt for this to spark more interest in the company's stock. Since these rights come at a discount, they tend to dilute the stock's price, which means the TERP usually ends up lower than the price before the offering.

Calculation of a Theoretical Ex-Rights Price

The TERP gets calculated right after the rights offering wraps up on its last day. This makes the stock's price a bit arbitrary during the period, potentially setting up more arbitrage trades.

Here's the straightforward way to estimate TERP: take the current market value of all shares before the rights issue, add the total funds raised from selling those rights, and then divide by the total shares after the issue. That gives you the value per share post-offering.

During the offering, investors of all kinds can speculate on how many shares shareholders will actually take, though usually only current ones can participate. Speculation hinges on the number of rights available, expected demand, and the offering price. Companies disclose this info in various ways, which can complicate estimates even more.

Important Note

Keep in mind that the theoretical ex-rights price (TERP) is often lower than the stock's price before the offering because rights offerings are usually discounted, diluting the stock price.

Investor Analysis

As an investor, you can stack the TERP against the current share value and your outlook on future growth. Since rights are discounted, more exercises mean more dilution to the stock price. But during the offering, supply and demand still drive the market price, so even with dilution, strong investor demand can push the price up. If you're bullish on the stock for the long haul, this offering might motivate you more, while bearish or short-term players might not see the same potential.

Real-World Example

Take ABC Company, where management decides on a rights offering. The terms let each shareholder buy new shares based on their current holdings percentage, all at a discount to the market price. You, as a shareholder, can use the TERP to gauge what the shares might be worth after the issue. This will differ from today's market price.

Before the offering ends, you could calculate multiple TERP estimates under different scenarios, like if 25% of shares are bought versus 50%, 75%, or 100%. The more shares purchased at that discount, the bigger the dilution when they're issued.