What is stock dilution? How does it impact shareholders?

Summary

• Stock dilution is a way by which a corporation issues fresh shares and brings down the ownership percentage of existing shareholders.
• Stock or share dilution can potentially reduce the value of shares held by the company’s pre-existing shareholders.
• The announcements regarding stock dilution are made by the company during investor calls or in fresh prospectus.

Stock dilution is defined as a process by which a corporation issues fresh shares, increasing the number of outstanding shares, and brings down the ownership percentage of existing shareholders. Stock or share dilution can potentially reduce the value of shares held by the company’s pre-existing shareholders. Thus, stock dilution can generally have a negative impact on shareholders who hold ownership in the company.

The company can dilute its stock in several ways. The announcements regarding stock dilution are made by the company during investor calls or via a fresh prospectus.

Suppose a company has a total of ten shareholders. Each shareholder hold 10% ownership in the company. In this way, these shareholders with voting rights would exercise 10% control in making decisions.

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Now, let’s assume the company issues ten new shares. These shares are purchased by a single investor. Thus, the company now would have a total of twenty outstanding shares. The single investor who purchased all the new shares would now have a 50% stake in the firm.

However, the pre-existing shareholders would now hold 5% control in making decisions of the company, since their ownership has been diluted after issuance of fresh shares.

However, dilution doesn’t necessarily mean the dollar amount of the investment changes after the company issues fresh shares.

Other than the above-mentioned example, there are several other ways by which stock dilution happens.

How stocks become diluted

Exercising options: Companies generally grant their employees stock options in place of cash or stock bonuses. The employees can exercise these contracts by converting options to shares and sell them in the market. It results in dilution of existing shares.

Share conversion: There are companies which issue convertible debt. The holders of the debt can choose to convert their securities into shares and dilute the ownership of existing shareholders. There are cases when convertible debt gets converted to common stock at some preferential conversion ratio. In addition, convertible equity, also known as convertible preferred stock, generally converts to common stock on a preferential ratio.

Capital raise: The companies also issue additional shares (secondary offering) when they look to raise fresh capital to fund their growth.

New acquisitions: In case a company is buying a new firm, it may offer the latter’s shareholders new shares in its company.

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What stock dilution means for investors

Even as the value of shares held by a company’s pre-existing shareholders gets reduced after stock dilution, there are a few positive outcomes too for shareholders. The issue of fresh shares may be an indication that the company has likely boosted its revenue.

Similarly, stock dilution may send signals to investors that the company might be acquiring its competitors, opting for some strategic partnership, or making investment in a new product. It may result in the stock’s value rising in the long run, even if it struggles temporarily.

Stock dilution can have a significant impact on an investor’s investment portfolio since the company adjusts its earnings and valuation. Thus, investors should always keep a track of any stock dilution announcement so that they are not caught unawares.

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