Dilutive stock is any security that dilutes the ownership percentage of current shareholders - that is, any security that does not have some sort of embedded anti-dilution provision. The reason why dilutive stock has such negative connotations is quite simple: a company's shareholders are its owners, and anything that decreases an investor's level of ownership also decreases the value of the investor's holdings.

Ownership can be diluted in a number of different ways:

1. Secondary Offerings: For example, if a company had a total of 100 shares on the market and its management decided to issue another 100 stocks, then the owners of the first 100 stocks would face a 50% dilution factor. For a real life example of this scenario, consider the secondary offering made by Google Inc. in the fall of 2005. The company decided to issue more than 14 million shares of common stock to raise money for "general corporate purposes", and it diluted then-current holdings.

2. Convertible Debt/Convertible Equity: When a company issues convertible debt, it means that debtholders who choose to convert their securities into shares will dilute current shareholders' ownership when they convert. In many cases, convertible debt converts to common stock at some sort of preferential conversion ratio. For example, each $1,000 of convertible debt may convert to 100 shares of common stock, thus decreasing current stockholders' total ownership.

Convertible equity is often called convertible preferred stock. These kinds of shares usually convert to common stock on some kind of preferential ratio - for example, each convertible preferred stock may convert to 10 shares of common stock, thus also diluting ownership percentages of the common stockholders.

3. Warrants, Rights, Options and other claims on security: When exercised, these derivatives are exchanged for shares of common stock that are issued by the company to its holders. Information about dilutive stock, options, warrants, rights and convertible debt and equity can be found in a company's annual filings.

For more information on shareholder dilution and its costs, check out our Accounting And Valuing ESOs Feature and A New Approach To Equity Compensation.

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  2. What is the difference between earnings per share (EPS) and diluted EPS?

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