The Disadvantages of a Dilution of Shares

by Cynthia Hartman

When investors buy stock in a company, the company gains financial capital it needs to grow. Investors control the proportion of the company they own, based on the number of shares they purchased. However, companies can issue additional shares of stock, reducing each shareholder's proportion of the company. This can have a dramatic negative effect on the shareholder's investment.

Share Dilution

"Share dilution" means a company has issued or plans to issue new shares of its stock, while not increasing the value of the company. The company can choose to issue new common stock, warrants or preferred stock conversions. Stock options granted to new employees are a source of potential stock dilution if the employees exercise those options. Some firms periodically buy back some of their stock to reduce the number of shares outstanding and to control the stock's dilution.

Dilution and Earnings per Share

"Diluted earnings per share" represents a company's ratio of earnings per share, or EPS, assuming that all issued warrants, stock options and other instruments convertible to common shares were executed. The firm could have a favorable EPS that satisfies investors, but a share dilution is likely to lower it by spreading earnings over a larger number of shares. In other words, each shareholder receives less earnings for each share held.

Secondary Offerings

Companies raise cash by offering more shares of stock. Some might compare this to a second public stock offering. History shows that share dilutions usually result in a depressed stock price, which penalizes investors. Banks have used new stock issues to spread losses over a larger number of shares, and to bring in new cash. Investors see this as the bank's troubled attempt to raise money in a difficult environment.

Shareholder Sentiment

When companies issue new shares while the company's value holds constant, each share represents a smaller ownership proportion of the company. For investors with large stakes in the company, this can substantially dilute their voting rights.

About the Author

Cynthia Hartman started writing in 2007 and has written for several different websites. She brings more than 20 years of experience in finance and business ownership. Hartman holds a Bachelor of Science in finance and business economics from the University of Southern California.

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