What is Share Dilution?

Imagine that you ordered a cake for five guests, but ten guests arrived at your home instead. Therefore, you will have to shares it with ten guests. The concept of share dilution works similarly.

Share Dilution

The term share dilution, stock dilution, or equity dilution refers to when a company issues new shares, thereby reducing the percentage of ownership of an existing shareholder in the company. Stock dilution also takes place when employees exercise their stock options or when noteholders convert their convertible notes. Each existing shareholder owns a smaller or diluted share of the corporation as the number of shares increases, which reduces the value of each share.

Let's assume a small business has ten shareholders, and every shareholder owns one share, or 10%, of the company. Each investor would control 10% of the company if they were given voting rights for decisions based on ownership.

Imagine a scenario where the company issues 10 new shares and a single shareholder purchases them all. The company now has 20 outstanding shares, with the new investor owning 50%. As a result, the original investors now own just 5% of the company - one out of each of the 20 shares outstanding - since their ownership has been diluting.

Diluted Earnings Per Share.

Dilutive securities are not included in basic EPS [earnings per share] but are divided by the average number of shares outstanding in the same period. EPS would be the same for a company without potentially dilutive securities since there would be none.

It is usually crucial for investors to know the share value when all convertible securities are converted. As a result, this reduces the earning power of each share. It is calculated and reported on the company's financial statements.

For diluted earnings per share calculation, use the simplified formula below:

Diluted EPS = Net Income − Preferred Dividends / WA + DS

Where:

• WA = Weighted average shares outstanding
• DS = Conversion of dilutive securities

Diluting Shares: How Does it Work?

Share dilution is done in various situations. These include:

• Conversion by holders of optionable securities: Employees, board members, and other individuals can exercise their stock options and convert them into ordinary shares, increasing the company's shareholding.

• Secondary offerings to raise additional capital: A company may issue additional shares to raise capital to fund expansion or service existing debt.

• Acquiring and selling new stock: A company may offer new shares to acquire or sell a firm. In addition, smaller businesses often give individuals shares in exchange for services.

Cause of Share Dilution.

While dilution reduces the value of shares, companies continue to issue additional shares. The most common causes of dilution are listed below:

• Companies may issue extra shares to raise capital for growth opportunities or to settle debts. Capital received from selling new stock on the stock market can increase the value and profitability of the company's stock.
• Shares may be issued to shareholders of an acquired company by a company that purchases another.
• Options and other optionable securities can also be distributed to employees. A stock option is exercised by converting it into shares of the company. As a result, there is an increase in the number of outstanding company shares.
• Smaller companies may occasionally issue shares to independent contractors.
• Some companies can bonds ,warrants, or other convertible securities. Usually, warrants are issued to lenders.
• Shareholders can dilute shares with a more significant stake in the company to remove other shareholders with a lesser stake in the company or obtain cooperation plans they usually would not approve.

Effect of Dilution

The number of additional shares issued and held can affect a portfolio's value during share dilution. The EPS of a company is also impacted by dilution, not only the price of its shares.

For example, a company's earnings per share (EPS) may be 50 cents before issuing new shares, but it may drop to 18 cents after dilution. However, the EPS might not be affected if the dilution increases earnings significantly. As a result of dilution, revenue may increase, which can offset any increase in shares, and the earnings per share may not change.

Public companies may calculate diluted EPS to assess the effects of share dilution on stock prices in the event of stock option exercises. As a result of dilution, the book value of the shares and earnings per share of the company decline.

The Bottom Line

A company's stock price is diluted whenever it issues new shares to investors, and share dilution can dramatically affect the value of your financial portfolio. A company is required to adjust its earning/share and share price ratio during this time. Share dilution is usually viewed negatively, but it can also be a positive sign of an acquisition that could boost stock performance in the future. It's still a good idea to keep an eye out for signs of stock dilution to avoid any surprises.