Companies have two main ways to raise capital: by taking on debt or by issuing equity.
The former is similar to a loan that an individual might receive at a bank; you get a sum of money and have to pay it back at a specific rate of interest. There can be caveats to this, but that is the basic mechanism. Debt holders get first priority if a company goes bankrupt.
Equity, of course, is different. A person who has a stake in a company is not usually legally entitled to a cash payout. They have a claim on whatever earnings that company generates, but if the business goes under, they are the last to receive whatever money is leftover. Additionally, when a company issues more equity, the equity holdings of existing shareholders will be diluted.
What is share dilution?
When a company is founded, it will have some number of "authorized" shares. This is the total number of shares that can be legally issued and is different from the number of "outstanding" shares, i.e. shares that are owned by investors.
Hypothetically, a company might be authorized to issue 20 million shares but has so far only issued 4 million of them. If those shares trade at $20, then the market capitalisation of the company is $80 million. The outstanding shares represent the full market value of the company, and if you owned 1 million shares, you would control 25% of the business.
Our hypothetical company can choose to issue more shares. Let’s say it issues a further 4 million. Since the total number of shares outstanding has doubled to 8 million, this reduces your stake by half - you now only own 12.5%. Consequently, the value of each individual share also halves because each share now gives you half as big a stake in the business. These new shares are sold to investors in the market in a "secondary offering," a process similar to an initial public offering (IPO).
Is dilution good or bad?
It depends on the situation, in my opinion. If you are a short-term investor or a trader, getting caught on the wrong side of a dilution can be painful. Just the announcement that a company is going to dilute its stock can cause the share price to fall.
From the company’s perspective (or from that of a long-term investor), the company is still worth the same amount of money it was before the dilution, so what really matters is how the management uses the cash that it receives for the newly-issued shares. Will it eventually make up for the initial loss of shareholder value?
If the company is efficient at allocating capital and there are good opportunities to do so, then the dilution will have been a success in the long run. However, if the money is not used effectively, this can seriously undermine shareholder value and public opinion, which can damage the company's ability to raise more money in the future.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Seth Klarman: How Much Research and Analysis are Sufficient?
- The Value Investor's Handbook: Be Approximately Right, Not Precisely Wrong
- Warren Buffett: Why Long-Term Bonds Are a Bad Investment
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
