Investing > Share Dilution Explained

Share Dilution Explained

Share dilution can affect your stake in a company. Every investor should know the reasons for—and the consequences of—dilution.

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Updated January 09, 2022

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Do you hate it when other people like the same music as you do?

Okay, maybe you’re not a total hipster and you’re one of those people who sees shared musical taste as a point of connection. But some of us pride ourselves on a highly individual taste in music, and that means another person knowing all the lyrics to our favorite Decemberists song make us feel just a little less special.

The thing is, when someone likes the same music you do, it doesn’t actually take anything away from you. But when you own stocks, and the company releases more shares of stock, that’s a different story. 🧐

In that case, it’s not just a problem of more people seeming just as cool as you because they own stock in the same company. When a company releases more shares of the stock, it actually changes the value of all the existing shares.

Whether you’re trying to figure out how Aurcana’s share dilution might affect you, or you’re brushing up on stock market tips before the U.S. enters a more inflationary period, it’s important to understand what a stock dilution is and how it impacts your portfolio. This guide will help you understand the basics of stock dilutions, and what to do when they happen to you.

So buckle up—let’s get to it! 🚀

What you’ll learn
  • What is Stock Dilution?
  • How Does Stock Dilution Work?
  • How to Calculate Share Dilution
  • Benefits of Share Dilution
  • Consequences of Share Dilution
  • Share Dilution vs. Stock Splits
  • Conclusion
  • Get Started with a Stock Broker

What is Stock Dilution? 📚

Even if you’re still learning how investing in stocks works, you probably know that a stock represents a small portion of a company. When you own stock in a company, you own a little piece of that company.

Stock prices change for all kinds of reasons: the market as a whole is doing well or poorly, the company releases some innovative product or starts raking in tons of profits, or hype around a company causes its prices to soar, such as Gevo, Inc.’s 170% increase in 2021. Share dilution is one of the factors that will definitely and immediately impact a stock.

In the case of GEVO, stock dilution prompted a trend of substantial growth. Image by TradingView.

But first: what exactly is stock dilution? Basically, it’s when a company releases more shares of its stock. Let’s take a really simple example: say your favorite company (Bob’s Lemonade Stand, or BLS) has 100 shares of stock. If you own 10 of those shares yourself, then you own 10% of BLS.

But after a while, BLS chooses to release additional shares – to keep the math really simple, let’s just say you release another 100 shares of BLS. Now, you still own 10 shares, but those 10 shares only represent 5% of the company instead of 10%.

Now, there are a lot of different reasons why a company might have chosen to issue more shares. There are also a lot of different impacts this can have on the shares you own – even if the percentage of the company you owned has gone down, that doesn’t necessarily mean the total value of your shares will take a dive. For example, the price of Lojas Americanas soared after they announced their merger and share dilution in November 2021.

However, this change in ownership would directly impact your voting power. If you now only own 5% of BLS, your vote is only going to account for 5% of the decision-making power. While this may not be a huge concern if you are trading stocks to make money, it is obviously important if your voice in the company is part of why you have chosen to invest. Let’s dive into the next section for more details on how dilution actually works and impacts what’s in your pocket.

How Does Stock Dilution Work? 🏗

You might have heard of stock splits, where a company creates new shares of their stock, but doles them out to existing shareholders to maintain their same ownership proportions. We already know that a stock dilution doesn’t work that way – in a stock dilution, new shares are doled out, and it does change the proportional ownership of existing shareholders.

So, why might a company choose to do this? There are several reasons.

If a company is making an additional offering, that might be because they are trying to finance new opportunities or pay off some debt. Mergers can often prompt stock dilutions, as a company might offer new shares to shareholders of the company they are acquiring. Share dilutions may also occur if employees convert their stock options into total shares, which typically increases how many shares exist overall in the company.

How Dilution Impacts Share Prices 💸

So, what does all this mean for the average retail investor? If you’re concerned about your ownership stake and voice as a voter, then there isn’t much advantage to share dilution. But if you are more concerned about the monetary value of your assets, it’s not necessarily a bad thing.

In the moment of the dilution, you may see a dip in the stock price, and thus a dip in the value of your holdings. This would happen just due to the number of shares increasing. However, it’s just a small part of the bigger picture of what determines a stock’s price. In addition to the dilution, market considerations such as the company’s overall performance, attitudes towards its sector as a whole, or global concerns such as threatened declines due to the omicron variant will always affect fluctuations.

In the case of Lojas Americanas, news of stock dilution resulted in a short spike in value after which the downward trend of the stock stabilized. Image by TradingView.

If a company is making a new offering, that is often a positive thing. Increasing revenue in order to fund new ventures or mergers can strengthen and grow the company, which will ultimately boost the value of your shares.

Of course, a dilution does also impact your earnings per share along with your voting power. You may be getting a smaller piece of the pie when it comes time to dole out any dividends at the end of the year.

Indicators of Upcoming Share Dilution 🕵️‍♂️

If all this has gotten you a bit nervous that your existing shares might be diluted, there are a few ways you can predict whether the companies you’ve invested in may be making this move sometime soon. 

New shares are typically offered when the company needs an influx of cash. That might happen because they are running low on money and can’t take on any additional debt, so offering new shares is a useful measure just to keep the lights on.

A more positive scenario is when the company sees new opportunities for growth or wants to take on new ventures, and needs a way to fund them. Rather than just trying to stay afloat, here the company is seeking investment capital.

How to Calculate Share Dilution 🧮

If you own a smaller percentage of the company, you’ll get a smaller share of the profits. If you’re going through a share dilution, you might want to know what exactly your new earnings per share (EPS) would look like. Following is the formula for your diluted EPS:

Diluted EPS = Net Income – Preferred Dividends / Weighted Average of Outstanding Shares + Conversion of Dilutive Securities

We can’t necessarily calculate what the dilution would be in the case of a new offering, but we can calculate your diluted EPS if all employees and board members were to convert their securities tomorrow.

Potential Benefits of Share Dilution 💰

If it looks like your shares might be diluted, don’t go ringing the alarm bells yet. As we mentioned above, the initiatives causing your company to make a new offering might lead to bigger things on the horizon. But even if that’s not the case, there can be some positives to share dilution.

If you’re trading penny stocks, share dilution can be even more common. Small companies will often use new offerings for an infusion of capital: for example, biotech startups will frequently hold offerings to fund their initial phases of research and development.

However, the volatility created in penny stocks when a share dilution occurs can create opportunity. It can be a good time to take a short position as the price drops in the short-term, or an opportunity to buy up some of the new shares, if you have faith in the company that they will come back strong after their initial dip.

Other Potential Consequences of Share Dilution ⚠

Let’s review the fundamental impacts that share dilution can have on a stockholder:

  • ☑️ Value dilution. The monetary value of your stocks may decrease. Because stocks are determined by supply and demand, and the company has increased the supply, it may take some time for demand to catch up.
  • ☑️ Earnings dilution. Your earnings per share will likely decrease now that there are more shares available.
  • ☑️ Voting power decreases. The percent of the company you own has decreased, so you accordingly have less power in the decision-making process of the company.

In addition to these effects, there are special considerations in some circumstances.

Share Dilution Scams 👨‍💻

Share dilution scams have occurred in the past. A scam is essentially when companies repeatedly make huge new offerings into the marketplace, apparently for no reason. This causes share prices to go down and down until they are essentially worthless. The company can then do a reverse split (which merges the shares so they become more valuable again), and repeat the entire scheme.

This scam is more common in unregulated markets. Still, know that if you see a company repeatedly making huge offerings with no apparent opportunities or expenses to fund, that’s a major red flag.

Private Companies & Startups 🚧

There are also unique factors for startups that are supported by investors. If you’ve invested in a private company, you can usually expect bigger swings in dilution of your ownership than in a public company. Private companies are often issuing highly significant amounts of new stock with each investment round, which of course alters the previous ownership structure considerably.

Managing expectations and the process of share dilution can be a huge factor in maintaining positive relationships as a company grows. This is an equal concern whether you’re doing a new round of investment for your lemonade stand from our example way at the beginning of this article, or if you’re Donald Trump raising $1 billion for a new social media venture.

Share Dilution vs. Stock Splits ⚖

Let’s pick our example back up of Bob’s Lemonade Stand. As a refresher, BLS has 100 shares, and you own 10 of them, or 10%. We’re working with nice round numbers here! In our share dilution example, BLS issued an additional 100 shares. There are now 200 shares of BLS, you still own 10 shares, so now you own 5% of BLS.

So what happens if BLS goes through a stock split? A stock split also changes the number of shares in circulation, but in very different ways. In a stock dilution, BLS is issuing an additional 100 shares to the marketplace: they are available to be purchased by the general public. In a stock split, BLS will issue an additional 100 shares to the existing shareholders, in proportion to the previous ownership in the company.

Stock splits make individual shares cheaper and easier to trade. That is one of the reasons why TSLA saw a huge uptrend after its stock split in mid 2020. Image by TradingView.

So, you owned 10 shares of BLS and that was 10% of the available 100 shares. BLS is now splitting their stock so they’ll have 200 shares available, but instead of offering 100 of those shares to the public, they’re giving them to you and the other owners. You now own 20 shares of BLS, and thus still own 10% of the company. It’s potentially a very different scenario, especially as we consider earnings per share and voting rights in the company.

Conclusion 🏁

If you haven’t decided to quit the stock market and open up Bob’s Lemonade Stand, then congratulations! You’ve made it to the end of this article and you now understand share dilution. This article has laid out the fundamentals of what you need to know if this might happen to one of the companies you’ve invested in.

Share dilutions can often be a negative thing in the short-term for existing shareholders. But always remember to dig beneath the surface, and see what this is telling you about the company as a whole. It may mean they’re struggling and need cash fast – or it might mean they’re growing in ways that will grant you huge payoffs down the road!

Share Dilution: FAQs

  • How Do You Know if a Stock is Diluted?

    When a company issues new shares, the previously existing shares become diluted. This could happen due to a new offering or employees and board members converting their options to shares.

  • Is Diluting Stock Legal?

    Stock dilution is legal. This is because it does not theoretically impact the monetary value of those shares, though often it does.

  • How Do You Tell if a Company is Diluting Shares?

    If a company makes a new public offering, that will typically be announced in advance. You can also search through most brokers to determine whether a company offers stock options that may dilute your shares in the future.

  • Can a Company Issue More Shares After IPO?

    Yes, companies can make new public offerings after their initial offering.

  • How Do You Protect Against Dilution of Shares?

    Companies can protect against it by not issuing convertible securities or making new public offerings to create new revenue. Investors without significant voting power typically cannot prevent share dilution.

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