Watching out for share dilution
Beginner Stock Market Investing, Online Stock Market Investing, Stock Market Investing Advice
Share dilution refers to the process by which the ownership stake of existing investors is reduced or diluted when a company issues additional shares. The outcome will often be a reduction in the value per share would and this is one risk of investing in stocks that many investors are unaware of or to which they pay inadequate attention. For example, let us say an existing business has 10 equal shareholders each of whom hold 10% of the business. The business then proceeds to issue an equal number of shares to a single new investor. The new investor would own 50% of the business while the share of the existing shareholders would reduce to 5% each because of the dilution caused by the new shares.
Some of the circumstances in which the holdings of existing shareholders can be diluted are:
- Holders of securities that have options to convert to equity exercising these options thus resulting in the creation of new shares
- Employees holding employee stock options exercising their right to convert their options into shares and
- The business choosing to raise funding by the issue of new shares to service business growth and expansion
- The business choosing to issue new shares to pay for services or acquisitions. For instance, corporate lawyers could be paid for their services by way of shares or the currency for acquiring a new business could be the issue of shares to the shareholders of the company being acquired
Retail investors should watch carefully for signs of share dilution because of the possibility of the resulting reduction in the value of the shareholding. Some of the circumstances in which companies may require additional equity are:
- The company may require additional funding to meet current liabilities and expenses as well as to finance growth. If there are existing covenants to their debt holders that prevent the raising of further debt, fresh equity may be the only alternative
- Ambitious growth plans may require large investments in marketing or plant machinery that it may be financially imprudent to finance through debt alone. Fresh equity will then be required to keep the debt/equity ratio within acceptable limits
- Employees and directors can influence the market price of shares significantly if they have large quantities of employee stock options. Large conversions may affect the price especially if they are sold immediately on the stock markets
One way in which you can calculate the impact of dilution on your investment is to work out the diluted EPS and then calculate the possible stock price after dilution by using the appropriate P/E ratio. The assumption is that all securities with options to convert to equity are exercised and the earnings are adjusted by deducting the value of preferred dividends. You can also calculate the impact separately for preferred stock that is convertible into equity and preferred debt that is convertible into equity. Because dilution can have a negative impact on the value of your portfolio, you should keep track of developments and, if necessary sell the shares if the dilution is not to your liking…
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