Theoretical Ex-Rights Price – TERP

What Is a Theoretical Ex-Rights Price – TERP?

A theoretical ex-rights price (TERP) is the market price that a stock will theoretically have following a new rights issue. Companies may use a new rights issuance to offer more shares to shareholders, usually at a discounted price. Stock prices are affected by new rights issuance because it increases the number of shares outstanding.

Theoretical Ex-Rights Price Explained

A theoretical ex-rights price is a consideration for stock issued through a rights offering. Typically, rights offerings are only available for current shareholders and only offered for a short time (approximately 30 days). Rights offerings usually give shareholders the option to buy a proportioned number of shares at a discounted, pre-specified price. The portion each shareholder is allowed to purchase is based on the shareholder's current stake in the organization. The goal is to raise additional capital with preference given to current shareholders.

Stock rights offerings can be a popular event for investors and traders as they may create potential arbitrage opportunities through the rights offering period. Overall the rights offering period can somewhat mitigate efficient market trading as it creates uncertainty over the stock’s price.

Generally, stock rights offerings are tools managers can use in raising capital through the stock. Management may choose to use stock rights offerings to generate additional interest in a company’s stock. Since rights offerings are commonly offered at a discounted price, stock rights usually have a diluting effect on a stock’s price. As such, the TERP is usually lower than the pre-offering market price.

Calculation of a Theoretical Ex-Rights Price

The theoretical ex-rights price is usually calculated immediately following the last day of a stock’s rights offering. This calculation makes the stock’s price somewhat arbitrary and potentially more enticing for arbitrage trades throughout the rights offering period.

The simplest way to create a TERP estimate is to add the current market value of all shares existing before the rights issue to the total funds raised from the rights issue sales. This number is then divided by the total number of shares in existence after the rights issue is complete. This calculation results in the value of an individual share after the offering.

Throughout the offering period, all types of investors can speculate on the number of shares expected to be taken by shareholders, but usually, only current shareholders can participate. The basis for speculation in this scenario involves the number of share rights available, the expected demand, and the rights offering price. Companies may have various types of disclosure for this information which can make the estimate even more difficult.

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

Investors can compare the TERP to the current value of a share and their expectations for future market appreciation. Since rights are offered at a discounted price, the more rights exercised, the more the stock’s price becomes diluted. However, throughout the rights offering period, supply and demand still affect the market price so while dilution is occurring, investor demand can still increase the prevailing market price. Investors who are bullish on the stock long term may be more motivated by the offering while bearish or short-term investors may not see as much upside.

Real-World Example

Management of ABC Company has chosen to issue a rights offering. The provisions of the offering allow each shareholder to buy shares in the offering based on the percentage of their outstanding shares. The new shares are offered to investors at a discounted price to the market price. Shareholders can use the TERP to determine the estimated value of the shares after the rights issue. This amount will differ from the current market price.

It is possible for multiple theoretical estimated values to be calculated for the stock before the end of the offering period based on some different scenarios. An investor might look at the TERP value if 25% of the shares are purchased in the rights offering versus 50%, 75%, or 100%. Overall the more shares bought, the greater the potential for dilution when the shares are sold at a discounted offering price.