A company can issue new shares in a variety of ways: sell stock to investors, grant stock options to its employees or contribute stock to employee retirement accounts or pension plans. The effect of new stock issuance on the share price depends on multiple factors such as how many shares are issued relative to the number of shares outstanding (already in circulation), over what time period, whether the shares can be freely traded, and general market conditions and investor sentiment.
Selling new stock to investors to raise capital is called a secondary offering. When a secondary offering is announced, the stock price usually drops. The most typical reasons are dilution, investor perceptions and company actions surrounding the offering.
When a company issues new stock, it increases the number of shares outstanding. Its earnings per share go down because the same amount of net earnings must now be divided by more shares outstanding. Investor stakes and share values are diluted. The larger a secondary offering, the greater the dilution.
Topping Stock Price
A company’s goal is to raise as much money as possible at minimal cost. The higher the stock price, the fewer shares a company must sell to raise the same amount. Since insiders know their companies better than anyone else, investors believe that secondaries often take place when the stock price is as high as it can get and start selling to lock in profits, pushing the stock price down.
If the offering price is significantly below the current stock price, investors who paid higher prices for their shares feel short-changed by the management, sell the stock and stay away from it. If a company loses investors' trust, its stock may languish for a long time as disgruntled investors stay away from it.
To minimize the negative effects of a secondary offering, a company may file a shelf registration, which allows it to sell new shares periodically as market conditions warrant. A shelf registration still causes dilution, and many investors use fully diluted share counts (as if all shelf stock has been issued) in their calculations. A shelf registration can still send a stock price down, but its effect may be less dramatic than that of a straight secondary offering.
Continuous Stock Issuance
Companies can also issue new stock through employee stock options or retirement contributions. When an employee exercises a stock option, he buys newly issued shares from the company at a predetermined price, but because exercising stock options is a continuous and gradual process, it does not have a noticeable impact on the current stock price. When a company contributes stock to employee retirement or pension plans, the shares tend to stay there for a long time without affecting the float (shares that can be freely traded) or the current stock price.
- “PassTrak Series 7: General Securities Representative License Exam”; Dearborn Financial Services; 2003
- “When to Sell. Inside Strategies for Stock Market Profits”; Justin Mamis, et al.; 1977