Stock Dilution: What It Means for the Stock Investor

Stock dilution occurs when the number of outstanding shares in a corporate entity are increased either through conversion of instruments that are deemed convertible or through outright issuance of additional shares. This leads to a reduction in earnings per share and controlling stake of the shareholders in the company.

Stock dilution is the opposite of stock reconstruction, where a company moves to reduce its number of outstanding shares.

How Stock Dilution Occurs

The main reason behind any stock dilution is either to raise capital, or to conserve cash. There are three common ways by which stock dilution occurs:

a)     During a public offering, shares are created out of existing shares so that a percentage of the company can be sold to the general public.

b)     Certain assets are deemed to be convertible. Warrants, options, rights and convertible bonds can be converted into stocks. This usually requires some exchange of money and that is why companies who are in need of finance do not mind giving out some of their stock in exchange for convertible derivatives.

c)      In some situations, a company may decide to either reward or compensate its workers in other methods apart from cash. An easy way to save that cash is to simply give out part ownership of the company in the form of stock options.

Now that we have an idea of what stock dilution is all about, whay are we even talking about it? What does a stock dilution mean to a stock investor?

A stock dilution has an impact on the value of the investor’s shareholdings as well as the value of the stock price in the following ways:

1. There is a reduction in the earnings per share of the stock investment.
2. Stock dilution reduces the controlling power of existing investors.
3. The share price of the stock will drop.
4. Reduction in market value of the shares in question.

Reduction in EPS

A reduction in the earnings for every share held by a shareholder is a common scenario seen in companies that use stock options as a method of reward or compensation to employees. Indeed anytime there is conversion of convertible derivatives into common stocks, there is a reduction in the degree of earnings that a share can produce.

Reduction in Controlling Power of Investors

When stock dilution occurs, the control that existing shareholders have over the company is equally diluted. Where a few persons were in total control of the activities in the company, a diluted stock situation now brings in other shareholders, many of whom have no idea of the company’s ideals or direction and whose interests may not necessarily be that of the company. This was the situation that caused the exit of Steve Jobs from the company he founded.

Stock dilutions can impact negatively on the process by which decisions are taken in the affected company, especially if the new shareholders have voting rights that give them the power to move away from the policy direction of the original shareholders.

Reduction in Market Value/Share Price

With so many shares created, there is a supply-demand imbalance which can cause the price of the stock to drop, especially if workers who have been compensated with stock options decide to cash out their holdings.

Another scenario is seen in the Pink Sheets/OTCBB markets, where companies with nano-priced stocks sometimes engage in follow-on offerings. The company founders issue additional shares and sell to the public as a means of making money, and then engage in reverse-stock splits, which end up ballooning the number of outstanding shares. Since the money realised from such secondary stock offerings is never really channelled into any productive ventures that will increase the company’s earnings, the end-result is a dampening of the value of the stocks of these companies.

Another example of reduction in market value and share price as a result of stock dilution is seen during an acquisition process. Acquisitions can be done using cash-only, cash + stock options or 100% stock options payment models. Acquisitions that utilize stock options usually leave the new entity with an increased number of outstanding shares which could potentially lead to a value dilution.

How to Get Around Stock Dilution

Unfortunately, stock dilutions are an integral part of many companies in the corporate world, and in some places, it is seen as a right and part of the welfare package for workers. If you are investing in such companies, then there is almost no way to get around stock dilutions. This means that for such an investment to become really profitable, the company’s earnings has to outperform the value reduction brought on by the stock dilution process.

As such, there are questions that an investor in a company with diluted shareholdings must ask?

a)    What is the capital generated by a primary or secondary offering to be used for? This is a dilemma that current Facebook shareholders are facing. Without a solid model for mobile advertising in place to maximally monetize its close to 900million users, the stock price of Facebook has lost close to 40% of its value since its IPO. Before investing in a company with a diluted shareholding, make sure there is a solid revenue model in place that will outperform the expected value reduction caused by the dilution.

b)    What are the fundamentals of the company? Is there a product which will command marketplace demand? Companies like Google and Apple have all had IPOs and secondary offerings, but because these companies have solid products that command marketplace attention, the stocks have outperformed any dilutional value reductions they incurred during their share offerings.

This is why it is very important to engage the services of professionals before buying any stock. The information that can be gained from such services is invaluable, as it can prevent an investor from putting his or her money into a drainpipe.