A:

When a 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.

But what causes the change in investor sentiment? To explain, let's start from the beginning.

Going Public

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 (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, 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 original investors' perspective — 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 percent!

How Investor Sentiment is Affected

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. Why would I need to know how many outstanding shares the shareholders have?

    Find out why shareholders should know how many outstanding shares have been issued by a corporation, and learn what happens ... Read Answer >>
  2. Why is the value of capital stock important to public shareholders?

    Understand what capital stock is and how it's issued and authorized. Learn why the value of capital stock important to public ... Read Answer >>
  3. 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 >>
  4. 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 >>
  5. How do I calculate earnings per share with simple capital and complex capital structure?

    Learn the difference between simple and complex capital structures and how the structure affects a company's calculations ... 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

    What's a Secondary Offering?

    A secondary offering is the issuance of new stock from a company that has already made its initial public offering.
  3. Investing

    The Dangers of Share Dilution

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

    The Dangers Of Share Dilution

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

    The Basics Of Outstanding Shares And The Float

    We go over different types of shares and what investors need to know about them.
  6. 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.
  7. Taxes

    How Your Government's Budgetary Decisions Impact the Public Sector

    Issues facing the public sector are not unlike some issues facing America’s oldest and largest companies, but with larger and broader impacts.
  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

    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. Dilution

    A reduction in the ownership percentage of a share of stock caused ...
  2. Subsequent Offering

    An offering of additional shares after the issuing company has ...
  3. Impact Day

    The date on which a corporation makes a secondary offering of ...
  4. Basic Earnings Per Share

    A rough measurement of the amount of a company's profit that ...
  5. Fully Paid Shares

    Shares issued in which no more money is required to be paid to ...
  6. Primary Earnings Per Share (EPS)

    One of two methods for categorizing shares outstanding. The other ...
Hot Definitions
  1. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange.
  2. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  3. Return On Equity - ROE

    The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability ...
  4. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  5. Whole Life Insurance Policy

    A life insurance contract with level premiums that has both an insurance and an investment component. The insurance component ...
  6. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
Trading Center