Understanding Stock Dilution
Stock dilution is when a company action increases the number of outstanding shares of its stock, typically reducing the ownership stake of current shareholders.
There are a number of ways share dilution can occur. Sometimes companies issue new stock as part of a secondary or follow-on offering in addition to the shares issued as part of its initial public offering (or IPO).
A company may create more shares through stock options for employees or board members as part of a compensation or retirement plan.
However the stock dilution happens, the increase in the number of shares means that each individual stockholder ends up owning a smaller, or diluted, portion of the company. This isn’t necessarily bad news for investors, however, as the issuance of these additional shares may be put toward the company’s debt or into research and development, potentially enhancing the company’s long-term value.
What Is Stock Dilution?
Stocks are shares of ownership in a company. Owning even one share of stock is like owning a tiny piece of the operations of a business.
When a company’s board of directors first makes the decision to take a company public, the IPO process allows a set number of shares of that company’s stock to trade on public stock exchanges. This initial number of shares is often called the “float.”
Any further issuance of stock (often referred to as a secondary offering) will result in the outstanding shares being diluted. (The same applies if the secondary offering occurs after a backdoor listing.) While this may or may not affect the price, it does impact current investors’ ownership stake.
Example of Stock Dilution
Let’s say a company has 10,000 shares of stock as part of its initial offering, and decides to issue 10,000 more shares as a secondary offering to raise more capital. In that case, existing investors could see a dilution factor of 50%. So if they previously owned 5% of the company, they would now own 2.5%.
Owing to a decrease in their percentage of ownership, stock dilution can also reduce the voting power of some shareholders.
How Does Stock Dilution Work?
There are any number of reasons that companies choose to issue secondary shares of stock. A company might want to give rewards to its employees or raise new capital.
Issuing new shares as a method of raising money can be a particularly desirable option because it allows a business to receive an infusion of cash without going into debt or having to sell any assets that belong to the company.
It should be noted that stock splits are separate events that do not result in dilution. And a stock buyback, which reduces the number of outstanding shares, can be a way of enhancing the value of the stock.
When a business has a standard split of its stock, investors who already hold that stock receive additional shares, so their ownership in the company stays the same. Dilution of stock only occurs when new shares are issued and sold to additional investors who hadn’t purchased shares before the secondary offering.
Reasons Why Stock Dilution Occurs
What is stock dilution, and why does it happen? When share dilution occurs, a company usually has its reasons for issuing the additional shares.
• Additional shares may be sold to pay down debt or increase capital for R&D or other purposes.
• Companies may offer stock options to employees as rewards or bonuses. When employees exercise these options, that increases the number of outstanding shares.
• A company might issue stock warrants or bonds as another way of raising capital. But when or if these are converted to shares, they can be dilutive.
• Some shareholders may push for an action that would end up diluting shares, as a way to reduce the power of smaller shareholders.
Is Stock Dilution Bad?
Stock dilution isn’t inherently bad or good, because the repercussions of diluting stock can affect all parties differently.
While all shareholders may see their ownership stake decrease, that will affect some more than others.
Even if shareholders are unhappy in the short term, the resulting cash infusion from making more shares available on the market can benefit the company long-term — which in turn might increase the value of the stock.
Stock Dilutions and Stock Price
When a company increases the number of outstanding shares, that action of course has an impact on earnings per share (EPS) as well as dividends — because there are now more shares on the market, or in investors’ hands. And when EPS and dividends effectively become diluted (or reduced) as well, that can impact the price per share.
So instead of looking only at basic EPS, investors should take into consideration convertible securities that may be outstanding as well. By understanding the whole picture, investors can arrive at the diluted earnings per share, which captures a more accurate picture of company fundamentals.
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How Does Stock Dilution Affect Investors?
When a company creates new shares of stock, the value of existing shares becomes diluted, meaning they decrease in value. If you’re thinking of cashing out stocks, this is something to consider.
Think of it like a birthday cake. At first, you and seven of your friends agree to each have one slice of cake. But then two of your other friends unexpectedly show up, also wanting cake. Now you have to slice the cake into 10 pieces rather than eight, so each piece will be smaller.
This scenario is similar to what happens when a company issues more shares of stock and stockholders see the value of their shares reduced.
The difference is that each share not only becomes like a smaller piece of the cake, but usually (but not always) becomes less valuable and entitles its holder to less company ownership and voting rights.
Stock Dilution and Dividends
For dividend-yielding stocks, dilution can also lead to smaller dividend payouts unless earnings per share rise enough to make up the difference.
Because more shareholders now have to be paid, paying the same dividend yield takes a heavier toll on profits.
If a company is only issuing new shares out of an attempt at raising new capital because their business is hurting, then they may have to cut dividends even deeper down the line or halt them altogether.
This has consequences for investors who hold equities for income. Dividend investors will do well to keep an eye on the number of shares outstanding for any stock, as well as how previous dilutions (if any) have affected dividends.
To be clear, dilution doesn’t have to affect dividends. Dilution cuts down on earnings per share (EPS) but not necessarily on dividends per share (DPS), but it’s likely it would.
While EPS measures a company’s profitability per each share of stock outstanding, DPS measures the value of dividends paid out to investors per each share of stock outstanding. A company can choose to keep DPS the same after dilution, although doing so will cut into the profits of their business to a larger extent than before.
The more dividends per share a company pays out, and the more shares there are, the more unsustainable the dividend is likely to become, since a company can only afford to pay so much of its profits out to investors.
The only way for big dividend payments to be sustainable is when a company is either growing rapidly or taking on lots of debt to finance its operations.
Other Stock Dilution Effects
Stock dilution has an impact on more than just the price of a stock or potential dividend payouts.
When additional shares are created, this reduces the stock’s earnings per share (there will be fewer earnings per share with more shares on the market) as well as the voting rights of the shareholder (holders of stocks sometimes get to cast a vote for important company decisions, like the addition or removal of board members).
In fact, income statements issued by companies often show both “basic” and “diluted” earnings per share (EPS) numbers. This allows for shareholders and investors thinking about purchasing the stock to see the effect that dilution would have if the maximum number of potential shares were to come into existence (through the use of unexercised stock options, for example).
Dilution of a stock can also have a positive impact on the stock’s valuation, however. That’s because the issuing of new shares being bought increases the stock’s market cap, as people buy those shares. If this momentum outpaces any selling caused by negative market views of the secondary offering, then share prices could rise.
Beyond the short-term, news-based influence of dilution, the long-term effects of new stock shares coming into existence depends largely on how a company’s management decides to spend the funds they just received.
Pros and Cons of Stock Dilution
While it’s easy to interpret stock dilution as a negative thing from the perspective of those who hold shares before the dilution occurs, the concept isn’t so one-sided.
When done in the right way for purposes that contribute to company growth, dilution can benefit both a company and its shareholders over the long-term.
When done recklessly or in an attempt at covering up bad business performance, dilution can provide a temporary cash flow boost that doesn’t solve any real problems and puts shareholders in a precarious position.
It comes down to whether or not a management team has a good reason for diluting their stock and what they choose to do with the funds raised afterward.
Pros of Stock Dilution
In some ways, dilution of stock can be a good thing. When new shares are used to reward managers and employees, this can indicate a company is growing and performing well, and that it wants to share some of its good fortune.
When new shares are issued at a price higher than what the stock is currently selling for, this can also be a win-win scenario. It indicates demand for shares while minimizing the share dilution that existing shareholders must endure.
Ideally, companies should have a good reason to issue new shares and use the resulting cash infusion in a productive manner. Raising money for a new product, research and development, or bringing on new and valuable employees might be some good reasons for dilution of a stock.
When a company dilutes its stock without good reason, or doesn’t use the proceeds in a productive way, then the cons of stock dilution are all that’s left.
Cons of Stock Dilution
In general, investors don’t take kindly to the concept of new stock shares being issued to internal shareholders, as it usually decreases the value of the stock and the ownership stake of those who already hold shares. To the investing public that has some kind of awareness of this, stock dilution can be seen as negative news.
Some of the things mentioned previously can also be considered cons of stock dilution: a decrease in earnings per share, less voting power for shareholders, or declining share prices.
Recurring, new stock issuances can be perceived as a warning sign by investors. If a company needs to keep diluting its stock to raise money, perhaps their business operations haven’t been performing well.
This perception might lead people to sell shares, resulting in a decline in the stock price. Sometimes this happens when a company merely announces that they might be issuing new shares in the future. The perception can become reality before anything even happens.
Stock Dilution vs Stock Splits
While share dilution and stock splits both increase the number of outstanding shares, a stock split has a different motive and different results.
A company often conducts a stock split to bring down the price per share. For example, a company trading at $200 per share could do a 4 to 1 stock split, bringing down the PPS to $50. Shareholders still hold the same dollar amount, but the number of shares they own has increased, so their ownership percentage doesn’t change.
| Stock Dilution | Stock Split |
|---|---|
| Increases # of outstanding shares | Increases # of outstanding shares |
| Used for capital infusion or for employee incentives/bonuses | Used to reduce the stock price |
| Investors’ ownership stake is reduced | Investors’ stake remains constant |
Understanding Corporate Buyback
The opposite of a company creating more shares is when a company buys its own shares back. This is sometimes called a corporate buyback and reduces the number of shares outstanding, usually leading to a rise in the price of a stock (due to the law of supply and demand).
While this might be good for shareholders in the short-term, it can be a bad thing for a company overall, since the money used could have been spent to improve business operations instead.
Sometimes stock can become highly overvalued due to the practice of corporate share buybacks, leading to precipitous drops in prices later on.
Sometimes companies issue public statements detailing their exact plans for dilution as well as their reasons for doing so.
This way, both current and future investors can prepare accordingly. The news alone can sometimes lead to a stock selloff due to the fact that the concept of stock dilution is usually interpreted in a negative way by most investors.
Investors would do well to monitor the amount of shares a company has outstanding. If the number keeps increasing, earnings per share are likely to decline or stay flat while investor’s voting rights diminish in their influence.
And while a drop in share counts can be a good thing, they can cover up a lack of growth by boosting earnings per share without any real underlying growth happening.
The Takeaway
Stock dilution — when a company issues additional shares — is neither good nor bad, but it does have specific consequences for shareholders, who typically see their ownership stake decrease.
In some cases, the additional capital raised by the shares in a secondary offering (one that occurs after the IPO) can benefit a company long term by paying down debt or adding to its assets or intellectual capital. But stock dilution can impact earnings per share, as well as dividend payouts, which in turn can impact the price.
But if the company sees a gain, growth, or expansion from the additional revenue, that could boost the stock price. It’s just important for investors to understand what a stock dilution might mean.
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