When a public company increases the number of shares issued, or shares outstanding, through a secondary offering, it generally has a negative effect on a stock's price and original investors' sentiment.
First, a company goes public with an initial public offering (IPO) of stock. For 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, or 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.
The Secondary Offering and Dilution
Subsequently, things are looking up for XYZ, which prompts management to raise more equity capital through a secondary offering in order to secure the necessary capital for operations. That secondary offering 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 original investors' perspective—those who became shareholders through the IPO—with the increase in the shareholder base, their level of ownership has been decreased. This consequence is referred to as the dilution of their ownership percentage.
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%.
How Investor Sentiment Is Affected
While an absolute increase in a company's net income is a welcome event, 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 those earnings 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. And the prospect of share dilution will generally hurt a company's stock price. That said, there are ways original investors could possibly protect themselves against dilution, for example, with contractual provisions that restrict a company's power to reduce an investor's stake after later funding rounds occur.
The Bottom Line
While IPOs are very exciting, they may not always be the best way for an investor to increase their stock market wealth. When researching investment opportunities, always pay attention to capitalization and dilution potential, and keep your eye on a company's EPS.