I've always had a vague idea of what a rights offering is, but I never really grasped its mechanics. Because they are obscure and sometimes misunderstood, rights offerings can also be mispriced ...

Did someone just say mispriced? Investors should respond to that word like Derek Zoolander to the word "relax." Since mispricings often create profitable opportunities, I decided to finally try to understand how rights offerings worked.

So what the heck is a rights offering?
In a nutshell, it's a coercive way for a company to raise money. In a typical IPO or secondary offering, a company raises money by selling new shares of stock to the public. Or so it seems.

Here's what actually happens: The company sells shares to an investment bank (the underwriter) at a predetermined price, thus eliminating the risk that the company won't be able to sell as many shares as it wants. The investment bank then uses its distributional might and army of brokers to sell the stock to the public. As payment, the investment bank collects a juicy underwriting fee.

A rights offering is similar to a secondary offering, except that the company sells shares directly to its current shareholders, bypassing the underwriting fee. However, not all shareholders necessarily want to buy more shares of the company. In order to do a bit of arm-twisting, the rights offering allows shareholders to buy shares at a deep discount to the current price, thus making it a no-brainer.

The math
Let's use a simple example. Suppose company A, a shipping company, wants to raise money to buy another vessel. Currently, it has one ship worth \$100 million (and we'll assume no liabilities) and 4 million shares outstanding, making each share roughly represent \$25 of the company's book value. The new ship costs \$50 million.

Suppose the company then offers each shareholder the right to buy additional shares at \$12.50 apiece. With shares worth \$25 on the open market, stockholders would pass up a whopping bargain if they didn't buy. And if the company can sell 4 million new shares in the rights offering at \$12.50 each, it'll raise the \$50 million it needs.

If the offering succeeds, the company's now worth \$150 million; divided among its now 8 million shares, that works out to \$18.75 apiece. Shareholders are no worse off; for every one share they previously owned, worth \$25, they now own two shares, collectively worth \$37.50.

In short, rights offerings are a great way to raise money from shareholders while avoiding an underwriting fee. Because it's such a no-brainer to exercise a rights offering -- assuming the exercise price is at a big discount -- the deal value transfers from those who, for whatever reason, do not exercise their rights (or sell their rights to someone else) to those who do. Foolish investors should always exercise their rights if such an offer arrives, or sell their rights at a fair price.

Show me the money!
Hope you're still with me. So how can investors use this knowledge to their advantage?

Think of rights offerings as deeply in-the-money call options. Because shareholders are given these options for free, sometimes they do weird things -- dump them, for example, because they either don't want to buy more shares, or don't really understand what they're doing.

Sometimes, rights offerings trade at substantial discounts to their intrinsic values. For example, if a stock is trading at \$10, and the company offers additional shares for \$5, uninterested shareholders might offer to sell their rights to buy new shares for \$3. The \$5 you'd pay for each additional share, plus the \$3 paid for the rights to do so, still add up to only \$8 --  a 20% discount to each share's market price. Of course, the price will fluctuate in the meantime, and it could go down. That doesn't make the prospect of a 20% discount any less appealing.

That said, keep in mind that rights offerings and their underlying stocks can be overvalued, too. Don't take shortcuts in the hope of finding free money.

Companies are constantly raising money via rights offerings to pay off debt or make acquisitions, so investors should be on the lookout for opportunities. USG (NYSE:USG) and Hayes Lemmerz (NASDAQ:HAYZ) are just two of the many companies that have used rights offerings to trim debt loads. More recently, Fortis announced a huge rights offering to help finance its portion of a bid to wrest ABN Amro (NYSE:ABN) away from Barclays (NYSE:BCS).

The key to rights offerings is not to make mistakes. Even if you don't want additional shares, make sure you manage your rights in a way that won't cost you money.

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool's disclosure policy protects your rights.