Share dilution occurs when a public company increases the number of outstanding shares available for trade. As more shares flood the market, existing shareholders’ ownership stakes shrink, or are “diluted.”
Every share of stock represents a slice of equity ownership in the issuing company.
When a company goes public with an IPO – initial public offering – they authorize a set number of shares. (The “float.”) But if the company issues more shares later in a secondary offering, their float increases.
Increasing the float size results in stock dilution. In other words, existing shareholders own a smaller slice of the company now than they did before the secondary offering.
Stock dilution occurs most often when:
Each of these methods can cause stock dilution when more shares are added to the equity pool, decreasing existing stockholders’ ownership percentages. In some cases, larger shareholders may even weaponize stock dilution to sway shareholder votes.
Say that Company A has 10 shareholders, each with 100,000 shares of stock. So the company has a total float of one million shares and each shareholder owns 10% of the company.
But in a year, Company A needs more cash, so it sells 10 new investors 100,000 shares each. Now, each shareholder owns just 5% of the company. While the new investors gained equity, Company A’s existing shareholders saw their ownership diluted.
Share dilution directly impacts investors by reducing their ownership stake in the company. Stock dilution also reduces your voting rights, as more outstanding stock correlates to more voting power in someone else’s hands.
Dilution can reduce the value of the existing shares, depending on what the company has received in return for them (e.g. additional cash for the balance sheet).It can also lower a company’s earnings per share, or EPS.
Since EPS is calculated by dividing a company’s income by its float, issuing more shares without raising earnings results in a smaller EPS. When a firm’s EPS drops, investors may get nervous, which can result in lower stock prices.
To prevent this outcome and assuage investor concerns, many public companies publish diluted and non-diluted EPS estimates.
That said, dilution isn’t always a bad thing. If the company uses the capital raised to invest in long-term growth, their earnings may rise – and take stock values with it.
To offset concerns about equity dilution, companies may announce issuances early, giving you time to prepare. They may also initiate share repurchase programs to ensure dilution impacts you as little as possible.
Even so, it’s common to view share dilution negatively, as it impacts your ownership and voting rights. On the other hand, issuing shares allows companies to fund growth without acquiring debt, which can boost their long-term bottom line – and your profits.
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