With the Dow Jones Industrial Average up 22% in 2019, it’s no wonder that investors are focused on only the good news coming out of the financial markets.
But a year-end Grinch actually does exist in the stock market, in the form of stock dilutions that can generate some wear and tear on your investment portfolio – but not in all cases.
What Is Stock Dilution?
Stock dilution is basically a decline in the percentage of share ownership by investors owning a particular stock, mostly due to the company issuing new shares of stock, which “dilutes” the value of existing stock owned by shareholders. The brand new stock issued by the company boosts the total number of shares available, triggering a dilution of the shares owned by shareholders.
Companies often issue new stock shares through mechanisms like stock options for employees, board members and business vendors and partners, restricted shares, or performance shares. Almost every time they do so, the value of the underlying stock is compromised. Or, share values may be diluted after primary or secondary stock issues, like an initial public offering, a preferred stock issuance, or the conversion or issuance of convertible bonds.
According to a 2015 study from Meridien Compensation Partners, stock dilution can be a big weight on portfolio performance.
Here’s how the study breaks share dilution down.
Using a simple example of a company with 100 shares outstanding, each share entitles the owner to 1% of company earnings and 1% of the voting power of the company.
If Jon held five shares of stock, he would own 5% of the company. Now assume the company reserves 10 new shares of stock to be used for stock options to executives. If all of those shares are issued, the company will have 110 shares outstanding, and Jon’s 5 shares will now command a smaller portion of earnings and voting power of the company. The formula to calculate the potential dilution (or overhang) of issuing these 10 shares is as follows:
- A = Incentive Shares Reserved in Plans but Unissued
- B = Incentive Shares Outstanding (unexercised options, unvested RSUs)
- C = Total Common Shares Outstanding
Potential Dilution (Overhang) = (A + B) / (A + B + C)
Applying this formula to the example above would result in 10 / (10 + 100) = 9.01%. This means that an existing shareholder’s earnings and voting power would be diluted by 9.01% if all 10 shares were issued.
Stock dilution also impacts more than just the value of shares held by the stockholder. It also curbs the value of the stock in other ways, including the stock’s earnings per share, the voting rights of the shareholder, and the stock’s market value.
Where stock dilutions can have a positive impact on company shares is in the stock’s valuation When a publicly-traded company issues new shares of its stock, that stock’s valuation grows higher as the added shares increase due to the new share sales.
How Does Stock Dilution Work?
The evolution of stock dilution isn’t all that complicated.
It kicks off when a publicly-traded company issues a secondary stock offering. A primary issue of company stock occurs well beforehand, with the company’s initial public offering of stock.
Companies will issue secondary shares of stock for myriad reasons. They may want to reward employees for valued work or offer new shares of stock to raise capital, for example. Companies that don’t want to stack up debt or shed company assets to gain access to much needed cash infusion will often turn to secondary stock offerings to raise money.
Once a company releases new shares of stock, the value of existing shares of stock decrease in value – or become diluted. Think of an entire apple pie with eight slices for eight individuals that attracts two more pie eaters to table. Now, 10 slices for 10 pie eaters are needed, thus diluting the size of the pie slices for the first eight pie eaters. It’s basically the same scenario for stockholders who see the value of their shares reduced as more shares are issued.
Losing value in shares owned isn’t the only way existing stockholders are penalized by stock dilution.
Consider a company that issues 1,000 shares of new stock to 1,000 individuals. Each participating shareholder now owns .1% of the company that provided the new shares of stock. If the company issues 1,000 more new shares of stock to 1,000 more people, the value of the existing shareholders shares declines to .05%.
Now, take the issue of shareholder voting power, which is based on the value of the shares owned by stockholders. In a stock dilution scenario like the one listed above, the first set of 1,000 shareholders would not see the value of their shares reduced by dilution, but their voting power, as well, given the fact the value of their holdings has been diluted.
How Do You Know if a Stock Is Diluted?
There are two stages to the stock dilution process that should give shareholders a heads-up on the potentially declining value of their stock shares.
The first clue is the “red flag” stage, when the company announces it is releasing new shares of stock.
In the event of a new share issuance, where a company announces new shares of stock, regulatory requirements mandate that publicly traded companies announce the new issuance stock shares in public (usually in the form of a press release or similar announcement from its investor relations office).
That may not be the case for companies granting new stock options to employees, business vendors or partners, although company stockholders must be listed in company financial documents.
If the company has a history of granting a substantial amount of stock options, you’ll hear about any new issuances through the company grapevine or by simply adding the company stock to a Google News alert, which should let you know when a company issues new shares of publicly-traded stock.
It’s also a good idea to check any share issuance filings available on a company’s 10-Q of SC 13G forms.
The second warning sign is when you notice the pricing patterns of your stock grow more volatile, which indicate the investing public is aware a company is aggressively issuing new share of stocks to raise money.
Veteran traders usually view substantial new share issuance activity as a sign of financial weakness for the company, with the stock being sold off at higher rates, leading to a decline in share price.
Pros and Cons of Stock Dilution
Where are the upside and downside of stock dilution? Here’s a thumbnail sketch.
Pros of Stock Dilution
- Stock dilution that rewards the value and performance of employees and managers is a sign of a growing, stable company that wants to share its good fortune with its people. Any time internal share ownership is increased, that’s a sign that the company and its workers are productive, and that those workers are highly valued. That’s a good scenario for any company.
- If a company releases new shares of stock at a price point that’s higher than the current share price, that’s a win for external shareholders, too, as share dilution is minimized.
Cons of Stock Dilution
- The investing public generally doesn’t like the idea of issuing new shares of stock to internal shareholders. That move decreases the value of the stock, in most cases, and decreases the ownership stake of existing shareholders.
- Often, investors will view a regular pattern of new stock issuances to raise money as a warning sign that the company isn’t in the best financial health, potentially leading to a selloff of company shares and a decline in the stock price.