Have you ever owned a stock that has had their shares diluted? Or looked at the news and wondered what share dilution is and its impact on the value of your investment? Most of the time, individuals seem to perceive share dilution as a negative thing. However, you may be surprised that this is not always the case.
What is Share Dilution?
Share dilution occurs when the company issues shares to new shareholders and, as the term suggests, the existing owner’s shares get “diluted”, and they own less as a percentage of the company than they did before.
They do this for multiple reasons, the most common ones being executive (or employee) compensation (by issuing Options – can exercised and converted into shares), or issuing shares to raise funds for further investments or to pay off debt.
Share dilutions usually have one of 3 outcomes. It could be good, bad or neutral. (No shit) But how do you tell which of the 3 it is?
What People Think
There is usually a negative reaction to the news of a share dilution. Usually, the issuance of Options to executives or employees causes a share dilution that negatively impacts existing shareholders. For example, the company decides to issue a whole bunch of options to the CEO of the company as compensation, he then converts the options into shares in the company. This will dilute the value of all existing shareholder’s shares and all the existing shareholders now own a smaller portion of the company and a smaller portion of future earnings.
E.g. You own 10,000 shares out of the company’s 1,000,000 shares. (You own 1% of the company) The board then decides to issue 50,000 shares worth of stock options to the CEO. He then decides to exercise the options and it becomes converted into shares.
Now that the company has 1,050,000 shares, your percentage of ownership in the company has decreased by almost 5% to 0.95% of the company. Consequently, it also means that your share of the future earnings of the company has decreased.
Dilution doesn’t always have to be a bad thing. Let’s say you own 10,000 shares of Company A. The company has 1,000,000 shares, so again you own 1% of the company. Company A has a EPS (Earnings per Share) of $1. The company’s shares are trading at $5, so the company’s current market value is $5,000,000 and your investment is worth $50,000. The company announces that it is acquiring a rental property worth $1,000,000 that earns $200,000 a year and it is going to issue shares to pay for the acquisition.
Since each share is trading at $5, the company will have to issue 200,000 new shares. Increasing the number of shares in the company to 1,200,000 shares. You now own 0.83% of the company. However, since the acquired asset would also have a $1 EPS ($200,000/200,000 issued shares) the earnings would not actually have been diluted.
In the same way, share dilution can actually be beneficial to existing investors. A share dilution is good when you end up with a smaller piece of a bigger pie. So if company A has a higher EPS than the existing company, let’s say $2. Then the future value of earnings per share would be higher once the acquisition has been completed.
We hope this helps you to understand the impact of share dilutions on your investments!
Stay tuned for next week’s article.