What is Dilution?

Dilution (also known as stock or equity dilution) occurs when a company issues new stock which results in a decrease of an existing stockholder's ownership percentage of that company. Stock dilution can also occur when holders of stock options, such as company employees, or holders of other optionable securities exercise their options. When the number of shares outstanding increases, each existing stockholder owns a smaller, or diluted, percentage of the company, making each share less valuable.

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Dilution

Understanding Dilution

Dilution is simply a case of cutting the cake into more pieces. There will be more pieces but each will be smaller. So, you will still get your piece of the cake only that it will be smaller than you had been expecting, which is often not a desired outcome.

A share of stock represents ownership in that company. When the board of directors decide to take their company public, usually through an initial public offering (IPO), they sanction the number of shares that will be initially offered. This number of outstanding stock is commonly referred to as the "float". If that company issues additional stock (often called secondary offerings) they have officially diluted their stock. The shareholders who bought the IPO now have a smaller ownership stake in the company.

While it primarily affects company ownership, dilution also reduces the stock's EPS (net income divided by the "float") which often depresses stock prices. For this reason, many public companies calculate both EPS and diluted EPS, which is essentially a "what-if-scenario". Diluted EPS assumes that potentially dilutive securities have already been converted to outstanding shares thereby increasing the denominator (the "float").

Share dilution may happen any time a company needs additional capital, seeing as new shares are issued on the public markets. The potential upside of share dilution is that the capital the company receives from selling additional shares can improve the company's profitability and the value of its stock.

Understandably, share dilution is not normally viewed favorably by existing shareholders, and companies sometimes initiate share repurchase programs to help curb dilution. However, stock splits enacted by a company do not increase or decrease dilution. In situations where a business splits its stock, current investors receive additional shares, keeping their percentage ownership in the company static.

Key Takeaways

  • Dilution occurs when a company issues new stock which results in a decrease of an existing stockholder's ownership percentage of that company
  • Dilution reduces the stock's EPS (net income divided by the float) which often depresses stock prices
  • Dilution is one way a company can raise additional funds, though existing shareholders are usually not thrilled when this happens

General Example of Dilution

Suppose a company has issued 100 shares to 100 individual shareholders. Each shareholder owns 1% of the company. If the company then has a secondary offering and issues 100 new shares to 100 more shareholders, each shareholder only own 0.5% of the company. The smaller ownership percentage also diminishes each investor's voting power.

Real World Example of Dilution

Often times a public company disseminates its intention to issue new shares, thereby diluting its current pool of equity long before it actually does. This allows investors, both new and old, to plan accordingly. For example, MGT Capital filed a proxy statement on July 8, 2016, that outlined a stock option plan for the newly appointed CEO, John McAfee. Additionally, the statement disseminated the structure of recent company acquisitions, purchased with a combination of cash and stock.

Both the executive stock option plan as well as the acquisitions are expected to dilute the current pool of outstanding shares. Further, the proxy statement had a proposal for the issuance of new authorized shares, which suggests the company expects more dilution in the near-term.