Complete Guide To Corporate Finance

AAA

Raising Capital - New Equity Sales

A company that has already held an IPO can sell new equity in what is known as a secondary offering, a follow-on offering or add-on offering. Usually, these kinds of public offerings are made by companies wishing to refinance or raise capital for growth. The money raised goes to the company through the investment bank that underwrites the offering. A secondary public offering is a way for a company to increase outstanding stock and spread market capitalization (the company's value) over a greater number of shares. However, secondary offerings dilute the ownership position of stockholders who own shares that were issued in the IPO.

Unlike an IPO, which includes a price range at which the company is looking to sell shares, the price of a follow-on offering is market-driven. Because the company is already publicly traded, it has been consistently valued by investors for at least a year before the follow-on offering is floated. Thus, any investment bank working on the offering will often focus on marketing efforts, rather than valuation.

From the existing shareholders' perspective, the issuance of add-on stock is a bad thing because it usually reduces the value of the stock they own. More shares mean that existing shareholders will see their percentage of ownership in the company decrease. They may also see the stock's earnings per share decline. However, if the add-on is able to increase earnings and shareholder value in the long term, it will generally be viewed as a positive decision.


Share Price and Secondary Offerings
Why do share prices fall after a company has a secondary offering? 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.

Suppose XYZ Inc. has a successful IPO and raises $1 million by issuing 100,000 shares. These shares 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. 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 $50,000 of additional equity. 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, 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. We'll discuss share dilution in greater depth later in this section.

Cost Of Issuing Securities
Related Articles
  1. Term

    How Market Segments Work

    A market segment is a group of people who share similar qualities.
  2. Active Trading

    Market Efficiency Basics

    Market efficiency theory states that a stock’s price will fully reflect all available and relevant information at any given time.
  3. Professionals

    Is A Stockbroker Career For You?

    Becoming a stockbroker requires a broad skill set and the willingness to put in long hours. But the rewards can be enormous.
  4. Economics

    Understanding Cost-Volume Profit Analysis

    Business managers use cost-volume profit analysis to gauge the profitability of their company’s products or services.
  5. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  6. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  7. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
  8. Investing Basics

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  9. Professionals

    A Day In The Life Of A Public Accountant

    Here's an inside look at the workdays of two experienced CPAs, to give you an idea of what it might be like to pursue a career as a public accountant.
  10. Professionals

    A Day in the Life of a Public Accountant

    There’s no typical day in the life of a public accountant, but one accountant’s experience may shed some light on what the career entails.
RELATED TERMS
  1. Tight Monetary Policy

    A course of action undertaken by the Federal Reserve to constrict ...
  2. Laissez Faire

    An economic theory from the 18th century that is strongly opposed ...
  3. Short-Term Debt

    An account shown in the current liabilities portion of a company's ...
  4. Audit

    An unbiased examination and evaluation of the financial statements ...
  5. Sortino Ratio

    A modification of the Sharpe ratio that differentiates harmful ...
  6. Climate Finance

    Climate finance is a finance channel by which developed economies ...
RELATED FAQS
  1. What should I study in school to prepare for a career in corporate finance?

    Depending on which area you want to specialize in, corporate finance can be one of the most competitive fields in business. ... Read Full Answer >>
  2. Why would a company issue preference shares instead of common shares?

    Preference shares, or preferred stock, act as a hybrid between common shares and bond issues. As with any produced good or ... Read Full Answer >>
  3. What is the difference between cost of debt capital and cost of equity?

    In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While ... Read Full Answer >>
  4. What is the difference between gross profit, operating profit and net income?

    The terms profit and income are often used interchangeably in day-to-day life. In corporate finance, however, these terms ... Read Full Answer >>
  5. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  6. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
Hot Definitions
  1. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  2. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  3. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  4. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  5. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  6. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
Trading Center