If a company in which you own shares dilutes its stock, you’re probably in for an unpleasant surprise: The shares you owned prior to the dilution aren’t as valuable as they were before the dilution. Much depends on the reason the company diluted its shares, as down the road the funds raised by the dilution could help the company’s earnings. If that doesn’t occur, however, the dilution is not good news for shareholders. There’s a reason stock dilution is also known as equity dilution.
Results of Going Public
To understand the effects of stock dilution vs. no dilution, examine what happens when the owners of a company decide to take it public. That results in an initial public offering, or IPO. At the time of the IPO, the company issues a specific number of shares; the term for these outstanding shares is “float.” Any secondary stock offerings dilute this float.
What Is Stock Dilution?
For many people, the word dilute often corresponds to liquids. For example, if you want to lessen the effects of an alcoholic beverage, you may pour some water into it. This dilution makes the drink less potent. Share dilution operates in a similar way.
Stock dilution occurs when a company issues new stock, and the current shareholders experience a lessening of their ownership percentage in the enterprise. When a company issues more shares, stockholders own a diluted percentage of the company, and the value of each individual share decreases. In some cases, a company may issue new shares at less than the current share price. If the stock is currently trading at $10 per share and the company is only able to obtain $8 per share for the newly issued shares, the value of the shares is diluted by 20 percent.
Think of stock dilution as a pizza at a party. You bought enough pizza to feed ten people, but two unexpected guests show up. Cutting the pizza into smaller slices isn’t a problem, but no one will get as much pizza as they would have, if the presence of the extra guests had not diluted their slices.
Stock Dilution Example
Another way to demonstrate stock dilution is via shares owned by individual shareholders. For simplicity’s sake, let’s say a company issues 1,000 stock shares to 1,000 people, which means each person owns .1 percent of the company. Later on, the company introduces a secondary share offering, involving another 1,000 shares issued to another 1,000 individuals.
Instead of owning .1 percent of the company, the earlier shareholders now own just .05 percent. Since every share owned represents voting power at the company’s annual meeting, every investor has less influence.
Why Do Companies Dilute Shares?
If stock dilution makes individual shares less valuable, why do companies issue new stock? The answer varies by the company’s needs. Some companies may issue new shares because they seek new capital for further growth opportunities. Other companies may issue new stock out of the need to service debt.
If a company purchases another business, they may issue new shares to that firm’s shareholders. A smaller company might issue shares to individual service providers. If a company offers stock options to employees, those exercising their stock options will have them converted into the company’s shares, which increases the number of shares.
A company may also issue convertible securities, either bonds or stock warrants. Warrants are usually issued to lenders. When the owners of these securities convert them, the conversion results in new stock shares.
Not Stock Splits
Investors shouldn’t confuse share dilution with stock splits, which is generally a positive. When a stock split occurs, more shares are issued to shareholders of record on the day the split happens. For example, in a 2-for-1 stock split, the number of shares doubles. Let’s say the company had 50 million shares prior to the split; afterward, it has 100 million shares.
An individual investor with 100 shares of the stock now has 200 shares after the split. While the actual share price is halved, the investor doesn’t lose money because they now own twice as many shares. Stock splits usually occur because the price per share is too high relative to competitors, preventing smaller investors from purchasing the shares.
Understanding Share Dilution Impact
The average stock investor may not pay much attention to a company’s announcement of new share issuance, but they should. When you own stock in a company, pay attention to the number of shares. When a company issues a lot of new shares, the earnings per share is unlikely to grow with the firm’s net income, since these earnings are now spread over substantially more shares.
Share Dilution Dangers
Depending on the number of shares held, dilution can greatly affect a portfolio’s value. Not only is the individual share price affected, but dilution may also affect the stock’s earnings per share. The EPS is the result of the company’s net income divided by the float.
If the EPS was 18 cents a share prior to dilution, for example, it may drop to 16 cents per share after the dilution, depending on the number of new shares issued and the company’s income. Of course, if the earnings increase significantly after a dilution because these funds helped boost revenue, EPS may not be affected.
Startups are notorious for issuing stock options to employees in lieu of other tangible rewards. That means when the employees exercise these stock options, existing shareholders experience stock dilution, lessening the amount they own in the startup. Those existing shareholders undoubtedly include the startup’s founder, who may have once owned 100 percent of the company and find they own less since issuing stock and stock options. That’s why another term for share dilution is “founder dilution.”
Closely Held Corporations
Share dilution affects every shareholder’s ownership percentage in a company, but unless you own a substantial number of shares, ownership percentage isn’t the first thing on your mind when share dilution occurs. That isn’t the case with closely held corporations. When only a few people own shares, each person tends to think of the percentage of the corporation they own, not the number of shares. Majority shareholders, however, can use share dilution to force out minority shareholders or make them accept actions they would normally not condone.
When shares in a closely held corporation are diluted, that could mean someone goes from owning 20 percent of the company to just 10 percent. In some circumstances, a majority shareholder in a closely held company could issue so many shares that the percentage owned by minority shareholders comes close to zero. Often, such actions result in a breach of trust claim filed by the minority shareholders. Other legal action depends on state law.
Understanding Stock Buybacks
The opposite of stock dilution by a company is stock buyback. When it buys its own shares back, basically taking them out of circulation, the overall number of shares are reduced. This generally means the price of the remaining shares increase. There is a downside if the company’s shares were overvalued at the time of the buyback, since the repurchase destroys part of the stock’s value.