What is stock dilution?
Stock dilution or share dilution happens when a company issues shares, and since issuing stock increases the number of outstanding shares, it essentially dilutes current shareholders' ownership.
This means that the shareholders with a fixed number of shares now own a smaller percentage of the total number of shares. Stock dilution can be detrimental to shareholders because it reduces their equity stake in the stock and, therefore, the value of the shares.
How stock dilution works
When you buy shares in a company, you own a piece of that business, and your ownership is calculated based on the shares you own relative to the total number of shares existent. When a company issues new shares, stock dilution happens since shareholders’ equity is diluted.
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 weary of share dilution.
Stock dilution example
Consider a stock that is trading at $1, and investor A owns 100 shares of the 1,000 shares outstanding. The company decides to issue 1,000 new shares, and while investor A will still own 100 shares of the company, its stake in the business, which was 10%, is now just 5%.
The market will also adjust the stock price to reflect and incorporate the share dilution into the price, and over time, the stock price will converge to $0.5 to reflect the same value the company had previously.
Why stock dilution happens
Stock dilution can happen for several reasons, but usually, there are 3 different types of scenarios. Either a company needs to raise capital to reduce its debt, grow, restructure, or acquire another business.
Stock dilution can also happen when the company issues new shares for a merger or acquisition, through the offer of bonds, or simply to raise additional capital to grow or operate the business.
The company may issue convertible bonds, which allow the holder to convert them into shares of the company. These bonds allow the holder the ability to convert them into shares. If bondholders choose to convert their bonds into shares, the existing shareholders will be diluted.
In mergers and acquisitions, it is common 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 a type of stock dilution, the newly formed business will be more valuable when acquisitions and mergers are completed. Therefore existing shareholders might be diluted, but they now own shares in a more valuable business.
Companies struggling to raise capital through debt might also consider issuing shares as a last resort option. If the lending conditions deteriorate and the company cannot issue bonds or debt at favorable terms, issuing shares is usually the last option.
Is stock dilution good or bad for shareholders?
Stock dilution is usually frowned upon by existing shareholders because it reduces the value of the shares they own. While the equity value of the company remains the same, and the number of shares that the shareholders own, their equity stake is always diluted when new shares are issued.
However, in some cases, like startups and growth companies, issuing shares is a common practice and a way for the company to continue to grow and expand. Since it is such a common approach taken by most growth companies, stock dilution is not so bad in these cases.
The critical point is the cost of capital and the returns generated with that capital. If the company can reinvest that capital at favorable rates, dilution might not be so negative. The most crucial aspect of generating returns for your shareholders is dependent on your return on invested capital (ROIC).
How stock dilution affects stock prices
Stock dilution is usually bad for shareholders, as their shares' value declines when new shares are issued. This is usually reflected in the company’s stock price, which tends to decrease when it issues new shares.
Therefore, if you are considering investing or trading a stock currently diluting its shares, you should keep this in mind.
While stock dilution is usually a bad sign for current shareholders, it varies depending on the company, and type of business, and the current market conditions. A high-growth company will often require lots of capital to invest and grow.
High-growth stocks are therefore known for issuing shares. This is a common way of assessing capital without further increasing the debt load of the company. If the cost of capital is lower than the growth, the company can generate new capital, then dilution might be a good option.