What is Stock Dilution?
Stock dilution is a decrease in the value of an individual share due to an increase in the number of shares.
Stock dilution happens when a company issues more shares. The result is that each share usually becomes less valuable. There are a few ways new shares go into circulation: One is when a public company issues additional shares through public offerings. Another is when owners of convertible securities, such as convertible bonds or convertible preferred stock, exchange them for shares. Stock splits don’t cause dilution because they supply new shares only to existing shareholders, in proportion to what they already own. Investors may want to understand the possibility and extent of dilution before making financial decisions.
A company issues 100 shares, and Christine buys 50. That means Christine owns 50 percent of the business. Later, the company has another public offering and issues 100 more shares. Christine still has 50 shares, but the total number of shares is now 200. Even though Christine didn’t do anything with her stock, she now owns only 25 percent of the company.
Stock dilution is like watering down a drink...
Say you’re making lemonade, and the recipe calls for one part lemon juice to four parts water. If you add six parts water, the lemonade gets diluted, and the taste isn’t as strong. Similarly, when a company adds more shares to the mix, the value of each share is diluted.
Stock dilution, also called equity dilution, is what happens when existing stockholders own a smaller stake in a company when it issues more shares. Stock dilution is similar to printing more money. When you put more money into circulation, each unit generally becomes less valuable. Likewise, as more shares go into circulation, each share is worth a little less.
Imagine you own one share out of 100 existing shares for a company. That means you own 1 percent of the business. Later, the company offers another 100 shares to the public. Now there are 200 total shares, and you still only own one of them. Now you only own 0.5 percent of the company.
Stock dilution is not necessarily bad, but existing shareholders usually dislike it. That’s because their ownership stake decreases without them trading any stock. Dilution also lowers earnings per share (a measure of profitability) and typically reduces a stock’s price. For obvious reasons, this is usually upsetting to shareholders. The more new shares are issued, the greater the dilution. Stock dilution can also affect voting rights. If newly issued shares come with voting power, existing shareholders may lose some influence in business decisions.
However, dilution can have upsides. If a company issues more shares, it receives more capital. With a fresh injection of money, the company can fuel growth or pursue new business ventures. Ideally, the company will invest the capital in a way that ultimately increases the stock price and dividends in the long run.
Investors have to determine how detrimental or beneficial dilution may be as they decide which stocks to buy and sell.
Dilution usually corresponds with a decrease in stock price. The greater the dilution, the more potential there is for the stock price to drop. Dilution can keep stock prices lower even if a company’s market capitalization (the total value of its outstanding shares) increases. If shares of a stock trade at $2 and stay that way after the number of shares doubles, the stock price remains the same even though the value of the company has grown. However, there are always many factors affecting stock prices, and looking at one variable may not tell you the whole story.
Shares get diluted when a company adds more shares to the total number currently outstanding. Here are the two most common ways that happens:
Someone cashes in convertible securities. Convertible securities are any securities that can turn into another security, typically stock. Some businesses issue convertible bonds — corporate bonds that can later be exchanged for a set number of shares — to raise capital. If the bondholder chooses to convert the bond into common stock, this will dilute the stock. Companies can also issue preferred stock that can be converted to a set number of common shares at a certain time. When owners of preferred stock exercise this right, it can result in stock dilution.
The company has another public offering. A public company can issue an additional batch of shares. The most common reason companies do this is to generate capital, perhaps to acquire another company or invest in a new product. Even if the reason is constructive, issuing more shares dilutes the company’s stock.
Stock dilution isn’t always predictable. To get a sense of the potential for dilution, some investors look at the company’s diluted earnings per share (EPS), a measure of profitability that is listed in the annual and quarterly reports public companies file with the Securities and Exchange Commission.
Diluted EPS is a “what if” measurement that calculates earnings per share (profit divided by the number of existing shares) if all outstanding convertible securities were exercised. Basic EPS, often listed near diluted EPS, measures the earning per share for the shares that are currently in circulation. Seeing the disparity between these two figures reveals how much potential there is for stock dilution. One reason to pay attention to this is that stock prices often decrease if EPS goes down.
Preventing share dilution is a responsibility that’s largely in the hands of the company. Businesses can prevent or limit dilution by:
Investors don’t prevent share dilution as much as they react to it. They can look for signs of dilution and consider how it would impact their investment. Investors may want to do their due diligence by researching whether a company plans to issue more stock or has a lot of convertible securities. They can also look at a company’s diluted earnings per share to understand the potential for dilution. What investors choose to do with the intel will depend on their personalities, preferences, and goals.
If a shareholder wants to retain his or her stake in a company, one option is to purchase more shares when dilution happens. Even though this costs money, it allows the investor to maintain the same ownership percentage.
Stock splits and stock dilution both involve companies increasing the number of shares circulating, but they’re far from the same. With a stock split, companies issue more shares to existing shareholders, in proportion to what they already own. Since there are more shares outstanding, this reduces the stock’s price. Stock splits don’t dilute shares since the ownership stake of each shareholder stays the same. Companies often undertake stock splits to make the stock price look more affordable.
Actions that cause stock dilution increase the number of shares overall without providing more shares to existing shareholders, making each share less valuable.
For example, let’s say you own 500 shares of a company’s stock. If the company does a 4-to-1 stock split, you would own 2,000 shares. The price of each share would decrease, but you would retain the same percentage of ownership, and the value of your total shares would stay the same.
In a different scenario, let’s say you have 500 shares, and the company decides to issue 100,000 new shares to the public. You keep the same 500 shares, but they will be diluted. You will own less of the company, and your shares will be less valuable.
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