TL;DR
- Stock dilution refers to the decrease in value of each share outstanding due to the introduction of new shares.
- Stock dilution can occur if a company decides to issue additional shares to raise money. This can happen if additional funds are needed for a company to grow, pay off debt, or simply run its business.
- Stock splits do not cause stock dilution.
- Stock dilution can affect the overall earnings per share of a company as well as an investors ownership percentage and voting power.
- Investors should weigh the chance of stock dilution when deciding whether or not to invest in a company.
What is stock dilution?
A stock, or share, represents part ownership in a company. When an investor decides to buy a share of a company, she is considered a part-owner. If a company decides to introduce new shares to the market, the ownership percentage of each share goes down. For example, if an investor owns two shares of a company that has 1,000 outstanding shares, she technically owns .2% of the company (2 divided by 1,000). If the company then decides to issue an additional 1,000 shares, her percent of ownership will decrease to .1% (2 divided by 2,000). The decrease in value of each share outstanding due to the introduction of new shares is known as stock dilution.
Why does stock dilution occur?
No investor wants to see their shares go down in value, so why would a company choose to dilute their shares? There are a couple of different reasons, and not all of them are bad.
If a company requires money to grow, pay off debt, or simply run its business, it will sometimes issue additional shares that investors can then buy. Though stock dilution looks negative at first glance, it can be positive if the company uses the additional funds raised in a way that creates greater returns for the company. On the other hand, if the company does not use the raised funds effectively, there may not be a return that outweighs the decrease in value caused by the dilution of shares. Stock dilution can also occur if a company offers stock options to new employees as a form of compensation, which frequently happens in the startup realm. When employees decide to exercise stock options, other shareowners experience stock dilution.
A common misunderstanding is that the dilution of shares occurs when a company issues a stock split. A stock split is when a company divides its shares into multiple new shares without changing the overall value of the company. For example, if you own one share for $20 and the company decides to issues a 2-for-1 stock split, your share ownership would go up to two shares, but each share would be worth $10. Therefore, a stock split does not dilute the value of each share, because the overall market value remains the same.
How stock dilution impacts investors
Investors should pay close attention to stock dilution, as it can affect the value of their investments. As mentioned, the introduction of new shares decreases the value and therefore ownership percentage of a share. In many cases, share ownership equates to the right to vote in major company decisions, such as the makeup of a companys board of directors. Therefore, a decrease in share value also means a decrease in voting power.
Investors should also be aware that stock dilution can impact the EPS or earnings per share of a company. EPS is calculated by dividing net income by outstanding shares, therefore it is a reflection of a companys ability to generate profit. Since stock dilution involves the increase of shares outstanding it could decrease a companys EPS. That being said, if the additional funds raised through secondary share offerings are used effectively, an increase in net income may result, which could leave EPS unaffected.
The potential for stock dilution can influence an investors decision to buy or sell stock in a company. If a company requires more money to grow or acquire new business, it may be a sign that additional shares will be offered. An investor should look for these signs and assess the benefit of remaining invested in a company that could experience share dilution in the near future.
Stock dilution calculation
If you are an investor in a company that recently issued new shares and you want to find out the diluted value of your ownership, you can simply take the number of shares you own and divide it by the sum of newly issued shares and the original shares outstanding. For example, if you own 10 shares and a company has 1,000 shares outstanding, you own 1% of the company. If the same company issues an additional 500 shares, the diluted value of your ownership in the company would decrease to .67% (10 divided by the sum of 1,000 and 500).
Use this calculator if you want an easy way to determine diluted share value.
Bottom line
At the end of the day, stock dilution can greatly decrease the value of an investment. A decrease in share value can cause a decrease in ownership percentage, voting power, and a companys overall earnings per share. Although share dilution appears to be all negative, it is often the result of a company raising capital through the issuance of new shares, which could lead to greater returns down the line. Regardless, the potential for stock dilution is a risk that should be analyzed closely by any person who is interested in investing in a company.