An increase in the total capital stock showing on a company's balance sheet is usually bad news for stockholders because it represents the issuance of additional stock shares, which dilute the value of investors' existing shares. However, the additional capital stock may benefit investors in the form of increased returns on equity through capital gains, higher dividend payouts, or both.
What Is Capital Stock?
Capital stock is the total amount of stock, both common and preferred, that a public company has the authorization to issue. The difference between common stock and preferred stock is that if a company goes bankrupt, preferred stockholders receive their share of the assets before common stockholders receive theirs (if there's anything left).
Common stock is what investors usually purchase, and companies don't always offer preferred stock. Note that while a company begins its life with a certain amount of equity shares, it may authorize the creation and issuance of additional shares if approved by the board of directors and existing shareholders.
Capital stock is the number of shares that can ever be outstanding or held by shareholders. The amount of capital stock that a company issues is usually initially stated in its company charter, which is the legal document used to start a corporation. However, a company commonly has the right to increase the amount of stock it's authorized to issue through approval by its board of directors. Also, along with the right to issue more shares for sale, a company has the right to buy back existing shares from stockholders.
Investors can find information about a company's capital stock in the shareholders' equity section of its balance sheet.
Disadvantages of Increasing Capital Stock
Increases in the total capital stock may negatively impact existing shareholders since it usually results in share dilution. That means each existing share represents a smaller percentage of ownership, making the shares less valuable.
As the company's earnings are divided by the new, larger number of shares to determine the company's earnings per share (EPS), the company's diluted EPS figure will drop.
Investors and analysts are wary if a company continually initiates additional stock share offerings, as this often indicates that the company is having difficulty maintaining financial solvency with current revenues and is in constant need of additional financing.
Benefits of Increasing Capital Stock
Despite possible dilution of shares, increases in capital stock can ultimately be beneficial for investors. The increase in capital for the company raised by selling additional shares of stock can finance additional company growth. If the company invests the additional capital successfully, then the ultimate gains in stock price and dividend payouts realized by investors may be more than sufficient to compensate for the dilution of their shares.
It is a good sign to investors and analysts if a company can issue a significant amount of additional stock without seeing a significant drop in share price.