There is a lot of misunderstanding regarding share dilution and stock splits. While it may seem confusing both concepts are very different from each other. But what is the difference between share dilution vs stock splits?
In this article, we will discuss the differences between share dilution and stock splits, how they affect stock prices, and whether they are good or bad.
What is share dilution?
Dilution causes the value of each share to go down because there are more shares outstanding. This means that each shareholder owns a smaller percentage of the company. The more shares that are outstanding, the less each share is worth.
How share dilution works
The way a share dilution works is pretty simple. To issue new shares, the company just goes to the market and sells them at a fixed price. Investors who buy these new shares become shareholders, and they're entitled to a portion of the profits (if any) that the company makes.
All they have to do is pay the market price for the shares. Some paperwork is involved in this process, but it's not complicated. The company just files a registration statement with the SEC, which lets the public know that new shares will be issued.
Once the shares are issued, they trade on the stock exchange just like any other shares.
Share Dilution Example
If a company has 100 shares outstanding and each share is worth $100, then the company has a market capitalization (value) of $10,000. If the company issues 100 new shares, it will then have 200 shares outstanding.
If the stock price reflects the same market cap the company had previously, each share will now be worth $50. This is because the equity ownership each share represents is cut in half.
In other words, each shareholder now owns 50% less of the company.
Why would a company dilute its shares?
There are several reasons why a company would issue new shares. The most common reason is to raise capital. Companies use the money they raise from dilution to fund their operations, expand their businesses, or pay off debt.
For example, if a company needs to raise $100 million, it can either take out a loan or issue new shares.
Another reason companies issue new shares is for employee stock options or restricted stock units. Stock options are a form of compensation that allows employees to purchase shares at a set price in the future.
If the stock price goes up, employees can make a profit by exercising their options and selling their shares. This can be used as a tool to motivate employees as they're given an incentive to help the company succeed.
Issuing new shares also allows companies to raise capital without taking on additional debt. This can be beneficial for new companies trying to grow or companies in a complicated financial situation that cannot take on more debt.
Of course, investor sentiment can be negative if a company dilutes shares for this reason alone. Issuing new shares is often seen as a less risky way to raise capital because the company does not have to pay back the money it raises.
However, there are some risks associated with share dilution, as it signals that the company could destroy shareholder value, and it leads to poor investor sentiment towards the company.
Issuing shares can also be a warning signal for shareholders, because it may signal that the company can’t raise capital by borrowing or issuing bonds.
What are the risks of share dilution?
The most obvious risk of share dilution is that it can hurt stock prices. When a company dilutes its shares, the value of each existing share is reduced. This most of the time leads to a decline in the stock price, which is proportionate to the reduced value of each share.
It can also make it harder for the company to raise capital in the future, by issuing shares because shareholders take dilution as a serious risk.
It makes it more difficult to raise money because potential investors will see that the company has already diluted its shares and they'll be less likely to invest. Another risk is that dilution can increase the volatility of the stock.
The lower stock price can also lead to more volatile swings in the stock price. This can be a problem for investors who are looking for stability.
Is dilution good for stocks?
Generally speaking, dilution is not good for stocks because your shares are worth less, but it can be good for the company because it gets more capital to grow. Share dilution is used commonly in startups and companies in an early growth stage, because it is a simpler way to raise capital, and it does not create a large debt burden on the company’s balance sheet.
In the short term, this can be detrimental to investors' portfolios, but it can provide long-term value if the company can use the extra capital to grow.
Does share dilution affect share price?
Most of the time a share dilution will be followed by a decline in the stock price, which is equivalent to the dilution that occurred. So for example, if the company doubles the number of outstanding shares, the stock price is expected to decline by 50%.
Receiving less equity ownership for the same monetary value will obviously deter future investors from buying the stock. Additionally, existing investors can feel that the company is destroying shareholder value instead of creating it. As a result, they might sell their shares, which would put downward pressure on the stock price. This will lower the share price for the company's dilutive actions.
What is a stock split?
Stock splits are when a company divides its shares into multiple pieces. This means that each shareholder will have more shares, but the value of each share will be lower. Divisibility makes it easier for investors to buy and sell shares, and it can also make a company's stock more affordable while increasing liquidity. There are two types of stock splits:
1. A stock split where each share is divided into multiple shares. For example, if a company has 100 shares and does a two-for-one stock split, each shareholder will now have 200 shares. Four-for-one stock splits and other divisible numbers are also common. A company would decide based on its number of shares outstanding and the desired share price.
2. A reverse stock split, where the number of shares is reduced. For example, if a company has 100 shares and does a two-for-one reverse stock split, each shareholder will now have 50 shares. However, the value of each share will double what it was before the split.
Sometimes, companies do reverse splits to increase the price per share so it meets a certain minimum. A minimum is required on some stock exchanges, and it can also make a company look more attractive to investors, as opposed to penny stocks, which can be considered too risky.
How a stock split works
The way a stock split works is also pretty simple. When a company wants to do a stock split, they announce how many new shares each existing shareholder will get.
For example, let’s say you own 100 shares of XYZ stock, and the company announces a two-for-one stock split. This means that you will now own 200 shares of XYZ stock. However, the price per share of the stock will be halved.
So, if each share was worth $100 before the split, it will be worth $50 after the split. The total value of your investment will remain the same, but you will now own twice as many shares.
If a company wants to do a stock split, they just have to file a form with the SEC and then announce the split. The shares will be split on a predetermined date, and then they will start trading at the new price on the stock exchange.
Why would a company split its shares?
There are a few reasons why companies might want to split their shares. For one, it can make the stock more affordable for small investors.
If a share is worth $100, it might be out of reach for some investors, but if it’s split into two shares worth $50 each, it might be more within their budget. By doing so, the company can widen its investor base.
Another reason might be to increase the liquidity of the stock. If there are more shares outstanding, it will be easier for investors to buy and sell the shares. This can make the stock more attractive to potential investors, who try to avoid illiquid stocks.
Lastly, a company might want to do a reverse stock split to increase the price per share. If a company has a lot of shares outstanding, the price per share might be quite low. By doing a reverse stock split, the company can increase the price per share to make the stock look more credible to investors.
As you can see, there are various reasons why a company might want to split its shares. It’s important to do your own research to see if a stock split is a good idea for the company you’re invested in.
What are the risks of stock splits?
The risks of splitting shares are mainly financial. For example, if a company splits its shares and the stock price falls, shareholders will lose money. There is also the risk that a company will not be able to meet the expectations of investors after a split.
Finally, there is always the possibility that a company will reverse its decision and cancel the split. While this is unlikely, it could happen if the stock price falls or the company's financial situation changes.
Remember that a stock split is usually a good sign, and tends to push prices higher. But other factors such as a company's financial health and the overall market conditions should be considered before investing.
A stock split can be great for lower-cost entry points, but it does not determine a company's success in the long term. Innovation from competitors, declining market demand, and other factors can have a significant impact, as well.
Stock Split Example
XYZ company's shares have risen to $2000. To make the shares more affordable and accessible to a wider range of investors, the company decides to do a one-for-two stock split.
This means that each shareholder will get two new shares for every one share they own. So if you own 100 shares of XYZ stock, you will now own 200 shares.
However, the price per share will be halved. So each share that was worth $2000 will now be worth $1000. The total value of your investment will remain the same at $20,000, but you will now own twice as many shares.
If successful, the stock split will have also increased the liquidity of XYZ company's shares.
Does stock split affect stock price?
Yes, in a positive way. When a company announces a stock split, the price of the stock usually goes up. This happens because investors see it as a sign that the company is doing well. If a company's shares are split, it means that the demand for the shares is high and the price has reached a level where the company wants to make it more accessible to investors.
This can be a good sign for the future of the company. The share price also goes up because more investors can buy the stock after the split. Previous share owners do not face any inclination to sell because the value and equity of their investment have not changed, so demand for the stock increases.
Differences between share dilution and stock split
The main difference between share dilution and stock splits is that share dilution reduces the equity value of each individual share, while stock splits do not.
Another difference is that investor sentiment is usually low when a company announces share dilution, while it is usually positive when a company announces a stock split. Share dilution happens when a company issues new shares, while a stock split happens when a company divides its existing shares into multiple shares.
Finally, share dilution is often done to raise capital, while stock splits are done to increase the liquidity and accessibility of a company's shares. While both share dilution and stock splits can have an impact on the price of a company's shares, they are two different things.
Advantages and Disadvantages of share dilution
One advantage of share dilution is that it can help a company raise capital. This can be especially helpful for small companies that may not have the resources to raise money in other ways.
In some situations, it can be the difference between a company being able to stay in business or not.
So while it may seem disadvantageous for an investor if the value of their shares has been diluted, it can save them from being worthless. Bankruptcy or even a loss of competitive advantage would be far worse.
For example, if the company needed money to buy a new piece of equipment, diluting shares may be the best option. If they needed to raise money to patent a line of groundbreaking products, it would be worth the dilution.
In these scenarios, investors might agree that the long-term benefits outweigh the short-term costs. Another advantage of share dilution is that it allows companies to give employees equity without having to spend cash.
This can be a great way to attract and retain talent, especially in the early stages of a company. Talent can be the difference maker between a company thriving or failing, so this is a significant advantage.
It can also help align employees with the goals of the company, as they will have a vested interest in its success. When the entire team is working towards the same goal, it can lead to amazing things.
There will be less turnover and more innovation. Of course, there are also disadvantages to share dilution. The main disadvantage of share dilution is that it can lead to a loss in value for investors. If a company issues new shares, the value of each existing share will be diluted. So while shareholders may own the same amount of shares, the overall value of their investment will be lower.
Additionally, it can make it more difficult for a company to raise future funds as investors may be less willing to invest in a company with diluted shares. More stock dilution may be needed to raise the same amount of money, which would further decrease the value of existing shares.
Finally, a disadvantage is that it can give employees too much power. If employees own a large percentage of shares, they may be able to make decisions that are not in the best interest of the company or investors.
For example, they may decide to all sell their shares at once and quit if the company is not doing well. This would be a major disadvantage for retail investors because they would likely see a significant drop in the value of their investment.
Share dilution can be a complicated issue with both advantages and disadvantages depending on your perspective. In the end, it is up to the management of the company to decide if share dilution is the best option for them. If done correctly, it can be a great way to raise capital and attract talent. However, it can also lead to a loss in value for existing shareholders.
Advantages and Disadvantages of stock splits
Stock splits can be either good or bad for investors. If a company's stock price has been rising, a stock split can make it more affordable for investors to buy shares. This can help a company's stock price continue to rise.
The liquidity can also be good for investors because it can make it easier to buy and sell shares. However, if a company's stock price has been falling, a stock split can make it look like the company is trying to hide something. This is because some investors may believe that they are trying to persuade new investors to hold their shares to offset any future losses.
This can lead to a decline in the stock price, and investors may lose confidence in the company. Another disadvantage of stock splits is that they can create a lot of paperwork for investors. When a company splits its shares, investors need to adjust the number of shares they own, as well as the price they paid for those shares.
This can be time-consuming and confusing. This can be a minor inconvenience or no inconvenience at all for some investors, others may find it frustrating. Overall, whether or not a stock split is a good thing depends on the individual investor.
It can be advantageous for an eager investor to finally be able to afford a piece of a rising company, but a stock split can also be seen as a red flag by more seasoned investors. The best thing an investor can do is to research a company thoroughly before deciding whether or not to invest.
How should investors react to stock splits and share dilution?
Overall, stock splits are seen as positive events. They indicate that a company's stock price is rising, and they make the shares more affordable and liquid. But as investors, it should not cloud your judgment on the company's underlying fundamentals and future prospects.
Dilution is often seen as negative by investors. However, it can be a necessary evil for companies that need to raise money to fund their operations and expansion. For example, if they use that money to increase their market cap tenfold, your 50% dilution may not seem so bad.
Each company has different needs and growth plans, so it is up to the management to decide whether or not to dilute shareholder value. As an investor, you should always be aware of the potential for dilution when considering investing in a company.
As a review, dilution happens when a company raises money by selling new shares or issuing new debt. This dilutes the value of existing shareholders' holdings. When a company is doing well and its stock price is rising, the last thing management wants to do is dilute shareholder value by issuing new equity.
So why would a company do it? It all comes down to growth. A company needs money to fund its operations and expand its business. If a company can't get that money from profits or cash flow, it will have to turn to the markets. By issuing new equity, the company can raise the money it needs to continue growing.
On the other hand, a stock split occurs when a company divides its shares into multiple pieces. This does not dilute shareholder value, but it does affect the stock price. After a stock split, the share price will be lower than it was before the split. However, this is usually seen as a positive event because it indicates that the company's stock price is rising and there is investor demand.
What causes a company to offer a stock split? There are a few reasons why a company might offer a stock split. The most common reason is that the company's stock price has risen to the point where it is seen as too expensive. A stock split will lower the price of the shares, making them more affordable for investors.
Another reason for a stock split is to increase the liquidity of the shares. When a company's shares are split, there are more shares available for trading. This can make it easier for investors to trade shares, and it can also make the shares more attractive to potential investors.