Stock represents the ownership share of a corporation. It is part of the firm’s stockholders’ equity, along with the accumulated profits, or “retained earnings," of the company. The “float” of a company is the number of outstanding shares of common stock authorized by the board of directors. Earnings per share is a firm’s annual net income divided by the float. Dilution increases the float, which usually cuts EPS and hurts the stock price. However, sometimes dilution can have a positive effect.
What Causes Dilution?
Dilution is caused by a corporation issuing additional shares of common stock, through any of three ways. If a company issues convertible securities, such as convertible bonds, convertible preferred stock or warrants, owners of these instruments can convert them into new common stock. Secondly, new shares can be created if employees exercise stock options. The last method is for a company to make a secondary offering of additional common stock to the public. However, a secondary offering need not be dilutive in the long run, depending on how the resulting cash infusion is used by management.
Stock Dividends and Splits
Stock dividends and stock splits increase the float without causing dilution. New shares are distributed to existing shareholders on a prorated basis. The company share price generally declines by the ratio of new shares to existing ones, but each shareholder's common stock stake increases by the same ratio. To the extent that additional shares increase the liquidity, or ease of sale, of the company's stock, shares may quickly recover a portion of their devaluation.
While dilution from conversions and stock options certainly hurts EPS and thus stock price, a company may use new shares to finance the takeover of another firm. As long as the acquiring company doesn’t overpay for the target, the acquired net assets, employees and operations add value to the acquirer commensurate with the amount of stock dilution. If the new assets contribute to earnings as predicted by the acquirer, the net effect may be neutral and not cause a significant change in the price of the acquiring company’s stock.
A company can substantially increase its float through a secondary offering of common stock. However, the cash received in exchange for the new shares increases the assets of the company. If the new cash can be used to fund projects that provide a return in excess of the shareholders’ required rate of return, earnings will climb, EPS will recover from the dilution and shareholders will be fairly compensated by higher stock prices. If the cash is used in ways that do not increase earnings, such as lavish executive compensation or golf junkets, existing shareholders will lose part of their ownership stakes and suffer lower stock prices without benefit.
A company can fight dilution through a share buyback program, in which the corporation buys up shares on a stock exchange at current market prices and retires the shares, removing them from the float. Buyback programs are designed to raise stock prices by cutting the number of shares claiming a portion of earnings. Another tool to fight dilution is to issue convertible securities with call provisions, which are options that give the company the right to force investors to sell their convertible securities back to the company for a specified price, thereby cutting potential dilution.
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