What is Dilution
Dilution is a result of a reduction in the ownership percentage of a company, or shares of stock, due to the issuance of new equity shares by the company. 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.
BREAKING DOWN Dilution
Dilution is a case where a company is divided into smaller pieces, meaning that current investors have a smaller portion of the overall pie. While it primarily affects company ownership, dilution also reduces the value of existing shares by reducing the stock's earnings per share. For this reason, many public companies calculate both earnings per share and diluted earnings per share, which takes into account all options and other dilutive securities.
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.
However, 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.
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.