One of the most common questions investors have is whether stock splits dilute their shares or not. The answer is no, and while it may seem confusing to understand the difference between a stock split and dilution both concepts are entirely different and have completely different effects on stock prices.
In this article, we will look at the main differences between a stock split and a stock dilution, and understand how it can affect shareholders and their returns.
What is a stock split?
A stock split happens when a company decides to increase its number of outstanding shares. While it may seem like a stock split could affect investors negatively, it does not. When a company does a stock split investors receive a certain number of shares equal to the number of shares they already own. Let’s look at a specific example of how stock splits work so you can understand the implications of a stock split.
Stock split example
Let’s consider company XYZ, which has 1,000 shares outstanding, and investor A which owns 100 shares of the company. If the company decides to do a 4-to-1 stock split, that means that the number of outstanding shares of the company will increase to 4,000. In the same way, investor A will receive 300 shares of the company to add to its existing 100.
At the end of the day, investor A has the same ownership of the company, and therefore its shares are worth the same as before.
Reverse stock splits
Investors should also be aware of reverse stock splits, which reduce the number of outstanding shares in the company.
What happens to your share when a stock splits?
When a stock splits, a shareholder will keep the same ownership of the business, although the number of shares it holds might increase and the value decline to adjust for the split, the equity value remains the same.
How dilution is different from a stock split
Share dilution happens when a company decides to issue new shares. There are several reasons why this might happen, but the main one tends to be to raise capital. When a company is unable to access debt markets, or can’t get credit from a financial institution, it can resort to issuing shares to raise funds.
When this happens the existing investors are diluted, which means that their equity ownership of the business decreases, since there are more outstanding shares, and the ones they have do not represent the same percentage of ownership of the company.
Companies may also issue shares if they are awarding stock options to their employees, or for a merger and acquisition deal with another company.
Stock split vs share dilution
When a company dilutes its shares it directly affects shareholders, while a stock split is just increasing the number of shares in a company without affecting the ownership of each stockholder.
The main difference between a stock split and share dilution is the goal of the company. While dilution mainly happens because a company needs to raise additional capital, and it is extremely negative to current shareholders, a stock split can actually be positive.
Is it better to buy before or after a stock split?
A stock split usually tends to have a very positive impact on the stock price, and according to researchers most stocks usually rise following the stock split announcement. The reason is that when a stock splits its liquidity increases, and at the same time it makes it easier for investors with less capital to invest in it.
Investors that once avoided investing in the stock due to its high price can now consider buying the stock. For this reason, traders anticipate this upward movement, and usually, stocks rise following a stock split announcement. Until the date of the split, the stock continues to rise and eventually returns to its value pre-split.
While it may seem like a stock split and dilution are the same thing - they aren’t. For investors, it is important to understand the difference between the two concepts, especially when it comes to dilution, and the negative effect it can have on your investment portfolio.