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When a company issues additional shares, this reduces an existing investor's proportional ownership in that company. This often leads to a common problem called dilution. The end result is that the value of existing shares may take a hit. This is a risk of investing in stocks that investors must be aware of. In this article, we'll look at how dilution happens and how you can protect your portfolio.

What Is Share Dilution?

Assume that a simple business has 10 shareholders and that each shareholder owns one share (10%) of the company. If each investor receives voting rights for company decisions based on share ownership, every shareholder has 10% control.

Suppose that the company then issues 10 new shares and that a single investor buys them all up. There are now 20 total shares outstanding, and the new investor owns 50% of the company. Meanwhile, each original investor now owns just 5% of the company (1 share out of 20 outstanding), because their ownership has been diluted by the new shares.

There are several situations where shares become diluted. These include:

  • Conversion by holders of optionable securities: Stock options granted to individuals, such as employees or board members, may be converted into common shares, boosting the total share count.
  • Secondary offerings where the firm is looking to raise additional capital: A firm may looking to raise new capital to fund growth opportunities or to service existing debt may issue additional shares to raise the funds.
  • Offering new shares in exchange for acquisitions or services: Instead of paying for an acquisition with shares, new shares might be offered to shareholders of the firm being purchased. For smaller businesses, new shares could be offered to individuals for services provided. For example, special counsel could be offered shares for representing the firm or in exchange for other legal services.

Warnings Signs Of Dilution

Because dilution can reduce the value of an individual investment, retail investors should be aware of warnings signs that may precede a potential share dilution. Basically, any emerging capital needs or growth opportunities may precipitate share dilution.

There are many scenarios in which a firm could require an equity capital infusion; funds may simply be needed to cover expenses. In a scenario where a firm does not have the capital to service current liabilities and the firm is hindered from issuing new debt due to covenants of existing debt, an equity offering of new shares may be necessary.

Growth opportunities are another indicator of a potential share dilution. Secondary offerings are commonly used to obtain investment capital that may be needed to fund large projects and new ventures. Investors can also be diluted by employees who have been granted options as well. Investors should be particularly mindful of companies that grant employees a large number of optionable securities. Executives and board members can influence the price of a stock dramatically if the number of shares upon conversion is significant compared with the total shares outstanding. (Learn more about employee stock options in our ESO Tutorial.)

If and when the individual chooses to exercise the options, common shareholders may be significantly diluted. Key personnel are often required to disclose in their contract when and how much of their optionable holdings are expected to be exercised.

Diluted EPS

Because the earnings power of every share is reduced when convertible shares are executed, investors may want to know what the value of their shares would be if all convertible securities were executed. Diluted earnings per share is calculated by firms and reported in their financial statements. Diluted EPS is the value of earnings per share if executive stock options, equity warrants and convertible bonds were converted to common shares.

The simplified formula for calculating diluted earnings per share is:

Net Income - Preferred Dividends

(weighted average number of shares outstanding + impact of convertible securities - impact of options, warrants and other dilutive securities)

Diluted EPS differs from basic EPS in that it reflects what the earnings per share would be if all convertible securities were exercised. Basic EPS does not include the effect of dilutive securities. Basic EPS simply measures the total earnings during a period, divided by the weighted average shares outstanding in the same period. If a company did not have any potentially dilutive securities, basic EPS would equal dilutive EPS. (Learn more in What is the weighted average of outstanding shares? How is it calculated?)

The formula above is a simplified version of the diluted EPS calculation. In fact, each class of potentially dilutive security is addressed. The if-converted method and treasury stock method are applied when calculating diluted EPS.

If-Converted Method

The if-converted method is used to calculate diluted EPS if a company has potentially dilutive preferred stock. Preferred dividend payments are subtracted from net income in the numerator and the number of new common shares that would be issued if converted are added to the weighted average number of shares outstanding in the denominator.

For example, if net income was $10,000,000 and 500,000 weighted average common shares are outstanding, basic EPS equals $20 per share ($10,000,000/500,000). If 10,000 convertible preferred shares that pay a $5 dividend were issued, and each preferred share was convertible into five common shares, diluted EPS would equal $18.27 ([$10,000,000 + $50,000]/[500,000 + 50,000]).

The $50,000 is added to net income because the conversion is assumed to occur at the beginning of the period so there would be no dividends paid out. Thus $50,000 would be added back, just like when after-tax income is added back when calculating the dilution of convertible bonds, which we will go over next.

If-Converted Method for Convertible Debt

The if-converted method is applied to convertible debt as well. After-tax interest on the convertible debt is added to net income in the numerator and the new common shares that would be issued at conversion are added to the denominator.

For a company with net income of $10,000,000 and 500,000 weighted average common shares outstanding, basic EPS equals $20 per share ($10,000,000/500,000). Assume the company also has $100,000 of 5% convertible bonds that are convertible into 15,000 shares, and the tax rate is 30%. Using the if-converted method, diluted EPS would equal $19.42 ([10,000,000 + ($100,000 x .05 x 0.7)] / [500,000 + 15,000]).

Note the after-tax interest on convertible debt that is added to net income in the numerator is calculated as the value of the interest on the convertible bonds ($100,000 x 5%), multiplied by the tax rate (1 - 0.30). (For more examples see our CFA Level 1 Study Guide Calculating Basic and Fully Diluted EPS in a Complex Capital Structure.)

Treasury Stock Method

The treasury stock method is used to calculate diluted EPS for potentially dilutive options or warrants. No change is made to the numerator. In the denominator, the number of new shares that would be issued at warrant or option exercise minus the shares that could have been purchased with cash received from the exercised options or warrants is added to the weighted average number of shares outstanding. The options or warrants are considered dilutive if the exercise price of the warrants or options is below the average market price of the stock for the year.

Again, if net income was $10,000,000 and 500,000 weighted average common shares are outstanding, basic EPS equals $20 per share ($10,000,000/500,000). If 10,000 options were outstanding with an exercise price of $30, and the average market price of the stock is $50, diluted EPS would equal $19.84 ([$10,000,000/[500,000 + 10,000 - 6,000]).

Note the 6,000 shares is the number of shares that the firm could repurchase after receiving $300,000 for the exercise of the options ([10,000 options x $30 exercise price] / $50 average market price). Share count would increase by 4,000 (10,000 - 6,000) because after the 6,000 shares are repurchase there is still a 4,000 share shortfall that needs to be created.

Securities can be anti-dilutive. This means that, if converted, EPS would be higher than the company's basic EPS. Anti-dilutive securities do not affect shareholder value and are not factored into the diluted EPS calculation.

Using Financial Statements to Assess the Impact of Dilution

It is relatively simple to analyze dilutive EPS as it is presented in financial statements. Companies report key line items that can be used to analyze the effects of dilution. These line items are basic EPS, diluted EPS, weighted average shares outstanding and diluted weighted average shares. Many companies also report basic EPS excluding extraordinary items, basic EPS including extraordinary items, dilution adjustment, diluted EPS excluding extraordinary items and diluted EPS including extraordinary items.

Important details are also provided in the footnotes. In addition to information about significant accounting practices and tax rates, footnotes usually describe what factored into the diluted EPS calculation. Specific details are provided regarding stock options granted to officers and employees, and the effects on reported results.

The Bottom Line

Dilution can drastically impact the value of your portfolio. Adjustments to earnings per share and ratios must be made to a company's valuation when dilution occurs. Investors should look out for signals of a potential share dilution and understand how their investment or portfolio's value may be affected.

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