What is dilution?
Dilution (also known as dilution of stocks or shares) occurs when a company issues new shares, which results in a decrease in the percentage of ownership of an existing shareholder in that company. Dilution of shares can also occur when holders of stock options, such as employees of the company, or holders of other optional securities exercise their options. When the number of shares in circulation increases, each existing shareholder owns a lower or diluted percentage of the company, which makes each share less valuable.
Dilution is simply to cut the cake into several pieces. There will be more pieces but each will be smaller. So you will still get your share of the pie, but it will be smaller than you expected, which is often not the desired result.
A share of the shares represents the property of this company. When the board of directors decides to make its company public, generally by an initial public offering (IPO), it sanctions the number of shares that will be initially proposed. This number of shares in circulation is commonly called the “float”. If this company issues additional shares (often called secondary offers), it has officially diluted its shares. Shareholders who bought the IPO now have a smaller stake in the company.
Although it mainly affects corporate ownership, dilution also reduces the EPS of the share (net income divided by the “free float”), which often lowers the share price. For this reason, many public companies calculate both EPS and diluted EPS, which is essentially a “simulation scenario”. Diluted EPS assumes that potentially dilutive securities have already been converted into outstanding shares, thereby increasing the denominator (the “float”).
Dilution of shares can occur whenever a company needs additional capital, since new shares are issued on the public markets. The potential benefit of diluting shares is that the capital the company receives from the sale of additional shares can improve the company’s profitability and the value of its shares.
Naturally, diluting shares is generally not viewed favorably by existing shareholders, and companies sometimes launch share buyback programs to help curb dilution. However, stock splits adopted by a company do not increase or decrease the dilution. In situations where a company splits its shares, current investors receive additional shares, keeping their ownership percentage in the company static.
Key points to remember
- Dilution occurs when a company issues new shares, resulting in a decrease in the percentage of ownership of an existing shareholder of that company
- Dilution reduces share EPS (net income divided by free float) which often lowers share prices
- Dilution is a way for a company to raise additional funds, although existing shareholders are generally not thrilled when this happens
General example of dilution
Suppose a company has issued 100 shares for 100 individual shareholders. Each shareholder owns 1% of the company. If the company then has a secondary offer and issues 100 new shares to 100 additional shareholders, each shareholder owns only 0.5% of the company. The lower ownership percentage also decreases the voting rights of each investor.
Example of dilution in the real world
Often, a public company broadcasts its intention to issue new shares, thereby diluting its current equity portfolio long before it actually does so. This allows investors, new and old, to plan accordingly. For example, MGT Capital filed a power of attorney on July 8, 2020, outlining a stock option plan for new CEO John McAfee. In addition, the press release disseminated the structure of recent corporate acquisitions, purchased with a combination of cash and stocks.
The executive stock option plan and the acquisitions should dilute the current pool of outstanding shares. In addition, the proxy contained a proposal for the issue of new authorized shares, which suggests that the company expects further dilution in the short term.