RBS Rights Issue

So, RBS will be doing a rights issue. Hmm... that wasn't really what I was hoping for, but I could have got out with a significant profit yesterday morning. I didn't, so lets look at the reasons why. But first, let's see how wrong I've been over the last few months...

My mistakes
My first purchase was made before I really understood the company, and I didn't leave myself much of a margin of safety. I've read Ben Graham now, so hopefully not a mistake I'll be repeating.

Here's why I first bought at a smidge under 400p:

• "The history of strong dividend growth" - which will now suffer a "discontinuity" in the carefully chosen words of Tom McKillop.
• "A P/E of less than 6" - doesn't help if (a) you have to issue more shares, and (b) your earnings are going to suffer.
• "the banking crisis is unfairly dragging down the share price". Remove the word "unfairly" and I was right :-)
• I listened to Fred Goodwin in his analyst presentation in December, and he was pretty positive. Bad move.

I recognised the potential downsides:

• "If RBS have to write off a load of bad debt, they may be forced into asset sales, cut dividend or rights issues. If the economy falters or further problems hit the banking sector, then the entire sector will suffer."

Asset sales, check. Cut dividend, check. Rights issue, check. Hmm... at least they didn't go bust.

My second purchase

Some time later I made my second purchase at the ex-divi price of 305p (just after Bear Stearns were bailed out). At that point my risk-weighted valuation of RBS was £50bn. I was confident that RBS would not be a wipeout, but recognised that it would almost certainly suffer.

The current position

So, where will I be post-rights? RBS are paying the final dividend in cash, so that's 23p off my initial purchase price of 399p. So 376p for that purchase, and 305p for the second. That makes an average of 348p. The rights issue is at 200p on an 11 for 18 basis - that's 122p per share. So adjusting for dilution I have effectively paid 470p per share (on the basis of the current 10bn issued shares).

Now, what are these adjusted shares worth? My risk-weighted expected earnings will increase. I was previously factoring in the possibility of a 10% complete wipeout chance, and the dilutive effects of a rights issue. On the other hand, the credit markets continue to deteriorate, so there are other factors to weigh up.

My latest estimated earnings were £4.6bn, and I thought a fair P/E was 10, so a market cap of £46.3bn was reasonable. That was accounting for a rights issue as an effective drop in overall earnings rather than a dilution.

I now estimate £5.35bn earnings (on the same basis). So I put a market cap on the post-rights-issue RBS of £53.5bn, and a fair share price of 535p (including payment for rights issue). Still above the 470p that I am effectively paying... I wouldn't buy more at that price, but I'm happy to hold.

Adjusting back for the extra 122p rights issue contribution, that puts a fair value in the current market of 413p. As of close of business today, the share price is at 345p. I spurned the chance to sell at just under 400p.

So, at what price would I buy more or sell? I will buy more given a discount of 40% to fair value (I like the long-term prospects but I already have a lot of this share so am not keen to increase my holding) so 250p. I will reduce my holding at fair value, so about 410p. I will sell out completely at fair value plus 10%, so 450p. All of that assumes no significant change in operating conditions. At 345p I'm holding and watching.