Dilution can make you poorer.
Beginning and intermediate investors often get around to learning what a P/E ratio is or what market capitalization means, but they often stay in the dark when it comes to understanding stock dilution. That's too bad, because stock dilution can matter a lot. (By the way, a P/E ratio divides a stock's recent price by its last year of earnings per share, yielding a rough measure of valuation. Market capitalization reflects a stock's market value, by multiplying its current stock price by its number of shares.)
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Stock dilution happens when a company issues more shares of its stock, or when more shares materialize, such as when employees exercise stock options or grants. Remember that a company first issues stock to the public via an initial public offering (IPO). After that, other issuances are called secondary offerings. Companies will issue more stock for various reasons. They might, for example, need to raise money in order to grow their business in some way or maybe to buy another company. Or maybe they're just running low on funds needed to run the business. To raise the needed funds, they could take on debt or sell some assets -- or they could issue more shares of their stock, which investors will buy.
An example might help. In simplest terms, imagine being at a party with seven other people and knowing that each person will be getting a slice of a large pizza that the hostess just made. Thus, you're expecting an eighth of the pie. But then two more people arrive, so the pizza is cut into 10 pieces. You still have ownership of a piece, but it's a smaller piece. It's similar with companies. If a company has 100 shares and you own 10, you own 10% of the company. But if it issues 20 more shares, then your 10 shares represent 8.33% of the company.
A rising share count can dilute the value of your shares.
Good or badMany assume that the issuance of more shares is unfailingly bad news, causing dilution. It actually can be not so bad, if the funds raised by selling the new shares are spent in a very productive way. For example, if the money is used to buy a company that will boost revenue and earnings, the stock-issuing company can end up coming out ahead. If the new shares don't boost the value of the company, though, then stock dilution has happened.
A lot of dilution happened in the late 1990s, before the Internet bubble burst, when many young companies without much excess cash yet were rewarding employees with pieces of the business in the form of stock options. Indeed, today income statements generally offer "basic" and "diluted" EPS numbers, so that investors and would-be investors can see the effect of dilution if the potential shares out there (such as unexercised stock options) were converted into stock. Check out a few examples below:
The flip sideThe flip side of a company issuing more shares is when it buys shares back, essentially retiring them, and thereby reduces its share count. This is good for shareholders -- usually -- because it boosts the proportional claim of remaining shares. But if the shares are very overvalued when they're bought back, the company is actually destroying some value, since the money could have been spent more productively.
As investors, we should keep an eye on companies' share counts. Rapidly rising share counts will make it hard for earnings per share to grow along with net income, as the earnings will be spread over more shares. And shrinking share counts, while often a good thing, can be a result of buying back overvalued stock or can mask slow growth if they're boosting EPS without investors' noticing. Share counts matter.
The article Understanding Stock Dilution -- and Why You Should Care About It originally appeared on Fool.com.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, ownsshares of Gilead Sciences and Microsoft. The Motley Fool recommends Gilead Sciences and owns shares of Gilead Sciences and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.