Stock dilution or equity dilution is when a company issues more shares, essentially diluting the ownership of current shareholders. There are several reasons that could prompt a company to issue more shares, but broadly speaking it is usually detrimental for shareholders.
When you buy a share in a company, you own a piece of that business. Companies will often have a number of shares outstanding that changes from time to time. The number of shares you own represents your ownership of the company. If the company issues more shares you essentially own a lower percentage of the overall business.
As an investor, you have a stake in the company’s equity. Although the equity value might remain the same, the increased number of shares means that the equity value of your investment is now lower. This is one of the reasons investors are often wary of share dilution.
Why does stock dilution happen?
Depending on the company, there are several reasons that could justify issuing more shares. Companies that want to raise capital, can often choose to issue shares. This can be done by offering shares outright or issuing convertible bonds.
The company may choose to raise capital while diluting existing shareholders. This is common among growth companies that need new capital to continue to grow.
It may also issue bonds that are convertible. Bonds are essentially debt that the company is able to issue. Sometimes companies will offer convertible bonds. These bonds allow the holder the ability to convert them into shares. If the bonds are converted into shares, the existing shareholders will be diluted.
It is also common in mergers and acquisitions to offer shares instead of capital. Sometimes companies are looking to make acquisitions or mergers, and do not have sufficient capital to close the deal.
When this happens they will often look for ways to offer the shareholders of the company they want to acquire or merge with, shares in the newly formed business. Although this is in fact dilution, when acquisitions and mergers are completed, the newly formed business will be more valuable. Therefore existing shareholders might be diluted, but they now own shares in a more valuable business.
Is stock dilution good or bad?
Stock dilution is usually frowned upon by existing shareholders. Because the value of their equity is being reduced. The fact is that dilution is not always a bad thing. Dilution happens because the company needs to raise additional capital. This is often because the lending conditions have deteriorated, and the company is unable to issue bonds or debt at favorable terms. When this happens the company is forced to dilute its shareholders in order to raise capital.
The key point here is the cost of capital. If the company is able to reinvest that capital at very favorable rates, dilution might not be so negative. This is the most important aspect of being able to generate returns for your shareholders is dependent on your return on invested capital. (ROIC).
Share dilution is never a good sign. However this can vary depending on the company, and the reason it is issuing shares. A high-growth stock will often require lots of capital to invest and grow. Therefore high-growth stocks are known for issuing shares. This is a common way of assessing capital, without further increasing the debt load of the company. Overall if the cost of capital is lower than the growth the company is able to generate with the new capital. Then dilution might be a good option.
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