A:

The best way to answer this question is to provide a simple illustration of what happens when a company increases the number of shares issued, or shares outstanding, through a secondary offering.

Let's start from the beginning. A company goes public with an initial public offering (IPO) of stock. In our example, XYZ Inc. has a successful IPO and raises $1 million by issuing 100,000 shares. These are purchased by a few dozen investors who are now the owners (shareholders) of the company. In the first full year of operations, XYZ produces a net income of $100,000.

One of the ways the investment community measures a company's profitability is based on earnings per share (EPS), which allows for a more meaningful comparison of corporate figures. So, in its first year of public ownership, XYZ had an EPS of $1 ($100,000 of net income / 100,000 shares outstanding). In other words, each share of XYZ stock held by a shareholder was worth $1 of earnings

Subsequently, things are looking up for XYZ, which prompts management to raise more equity capital through a secondary offering, which is successful. In this instance, the company only issues 50,000 shares, which produces additional equity of $50,000. The company then goes on to have another good year with a net income of $125,000.

That's the good news, at least for the company. However, when viewed from the point of view of the original investors - those who became shareholders through the IPO - their level of ownership has been decreased with the increase in the shareholder base. This consequence is referred to as the dilution of their ownership percentage.

Some simple math will illustrate this event. In the second year, XYZ had 150,000 shares outstanding: 100,000 from the IPO and 50,000 from the secondary offering. These shares have a claim on $125,000 of earnings (net income), or earnings per share of $0.83 ($125,000 of net income / 150,000 shares outstanding), which compares unfavorably to the $1 EPS from the previous year. In other words, the EPS value of the initial shareholders' ownership decreases by 17%!

While an absolute increase in a company's net income is a welcome sight, investors focus on what each share of their investment is producing. An increase in a company's capital base dilutes the company's earnings because they are spread among a greater number of shareholders.

Without a strong case for maintaining and/or boosting EPS, investor sentiment for a stock that is subject to a potential dilutive effect will be negative. Although it is not automatic, the prospect of share dilution will generally hurt a company's stock price.

For related reading, check out Markets Demystified and What is dilutive stock?

RELATED FAQS
  1. What's the difference between basic shares and fully diluted shares?

    Find out more about basic outstanding shares, fully diluted shares, the difference between the calculation of shares and ... Read Answer >>
  2. Why do companies release financial figures in terms of fully diluted shares outstanding?

    Learn why companies release their financial figures in terms of fully diluted shares outstanding so as to give a true picture ... Read Answer >>
  3. What is the difference between weighted average shares outstanding and basic weighted ...

    Outstanding shares refers to stock that is currently held by investors, including shares held by the public, and restricted ... Read Answer >>
  4. Why is a company's diluted EPS always lower than its simple EPS?

    Learn about diluted and basic earnings per share and why a company's diluted earnings per share is usually lower than its ... Read Answer >>
  5. What does it signify about a company if there is a large difference between its EPS ...

    Learn more about basic earnings per share and diluted earnings per share, what the ratios measure and what a large discrepancy ... Read Answer >>
  6. Why is an increase in capital stock on a company's balance sheet a bad sign for stockholders?

    Understand what capital stock represents for a company and understand the significance for investors when a company initiates ... Read Answer >>
Related Articles
  1. Investing

    How Does Dilution Work?

    Dilution refers to the reduction in the percentage equity ownership of a company due to additional equity being issued to other owners.
  2. Investing

    The Basics Of Outstanding Shares And The Float

    We go over different types of shares and what investors need to know about them.
  3. Investing

    The Dangers Of Share Dilution

    Share dilution reduces the value of an individual investment and can drastically impact a portfolio.
  4. Investing

    The Dangers Of Share Dilution

    Investors need to be aware of the existence of dilutive securities and how they can affect existing shareholders.
  5. Investing

    What are Issued Shares?

    Issued shares are the amount of authorized stocks a company’s shareholders buy and own. The annual report shows the number of outstanding shares.
  6. Investing

    Why Do Companies Care About Their Stock Prices?

    Read on to learn more about the nature of stocks and the true meaning of ownership.
  7. Investing

    Investment Valuation Ratios

    Learn about per share data, price/book value ratio, price/cash flow ratio, price/earnings ratio, price/sales ratio, dividend yield and the enterprise multiple.
  8. Investing

    Everything Investors Need To Know About Earnings

    We go over the concepts behind the excitement over the most important figure in the stock market.
  9. Investing

    What Are Corporate Actions?

    Be a savvy investor - learn how corporate actions affect you as a shareholder.
  10. Investing

    The 5 Types Of Earnings Per Share

    A look at the five varieties of EPS and what each represents can help an investor determine whether a company is a good value, or not.
RELATED TERMS
  1. Secondary Offering

    1. The issuance of new stock for public sale from a company that ...
  2. Basic Earnings Per Share

    A rough measurement of the amount of a company's profit that ...
  3. Outstanding Shares

    A company's stock currently held by all its shareholders, including ...
  4. Fully Paid Shares

    Shares issued in which no more money is required to be paid to ...
  5. Diluted Earnings Per Share - Diluted EPS

    Diluted Earnings Per Share (or Diluted EPS) is a performance ...
  6. Open Offer

    A secondary market offering that is similar to a rights issue ...
Hot Definitions
  1. Return on Market Value of Equity - ROME

    Return on market value of equity (ROME) is a comparative measure typically used by analysts to identify companies that generate ...
  2. Majority Shareholder

    A person or entity that owns more than 50% of a company's outstanding shares. The majority shareholder is often the founder ...
  3. Competitive Advantage

    An advantage that a firm has over its competitors, allowing it to generate greater sales or margins and/or retain more customers ...
  4. Mutual Fund

    An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities ...
  5. Wash-Sale Rule

    An Internal Revenue Service (IRS) rule that prohibits a taxpayer from claiming a loss on the sale or trade of a security ...
  6. Porter Diamond

    A model that attempts to explain the competitive advantage some nations or groups have due to certain factors available to ...
Trading Center