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Understanding Stock Dilution

October 30, 2020 · 8 minute read

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Understanding Stock Dilution

When a company reaches a certain size and meets certain requirements, its management can decide to offer shares of stock to the public.

This process is called an initial public offering, IPO, or simply “going public,” and is widely considered to be a major milestone in the development of any organization.

While an IPO will always be the first time any company issues stock that can be purchased by the general public on a major stock exchange, it might not always be the last.

There are certain circumstances that could call for the issuing of additional shares if management decides to do so.

What Is Stock Dilution?

Stock dilution, also known as equity dilution or simply “dilution,” happens when companies issue new shares of stock beyond what was issued at the time of the company becoming publicly traded.

Sometimes companies issue new stock shares by creating stock options for employees or board members as part of a compensation or retirement plan.

An increase in the number of shares outstanding means that each individual stockholder winds up owning a smaller and less significant, or diluted, portion of the company.

Stocks represent ownership stakes in their respective companies. Owning a 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 by offering shares of its stock to trade freely on one or more stock exchanges, a set number of shares will be offered. This initial number of shares is often called the “float.”

Any further issuance of stock (often referred to as secondary offerings) will result in the stock being diluted.

How Does Stock Dilution Work?

The process of stock dilution is relatively simple. It begins with a publicly traded company issuing a secondary stock offering. The first issuing of stock will have occurred before this, during the company’s IPO.

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.

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.

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.

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 ten pieces rather than eight, so each piece will be smaller than it otherwise would have been, had only eight of you each enjoyed a piece.

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 can be disastrous 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).

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.

Example of Stock Dilution

Let’s assume that a hypothetical company called Green Growth Galore (GGG) issued 500 shares to 50 individual investors during its initial public offering. Each investor holds 10 shares, which amounts to 2% of the company for each shareholder.

A few years after GGG goes public, they decide to bring on a new chief executive officer. This individual has a lot of experience and a long track record of managing successful companies, so GGG would like to provide a little extra incentive for this new executive to join their team.

They decide to provide that incentive in the form of stock options, which the new executive chooses to exercise immediately.

If this imaginary company (GGG) were to have a secondary offering and issue an additional 500 shares at this time to compensate their new CEO with, each shareholder would then see their ownership stake reduced by one-half to 1% (because there would now be 1,000 shares outstanding with each shareholder owning 10 shares). Their voting power would also be reduced by an equivalent amount.

As a result, all the effects of stock dilution listed above would also happen.

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.

Gaining Investment Savvy

While the topic of stock dilution might rarely come up in casual conversation, savvy investors who keep up-to-date on their stocks are likely to understand how stock dilution affects their investments.

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