What are Diluted Shares?
It’s essential to understand what happens when companies offer additional shares. Ampla explains diluted shares, and how you can protect against them.
Diluted shares are the result of a company offering additional shares of stock. The dilution outcome is a reduced proportion of ownership of the company to the existing shareholders.
There are many different reasons a company does this, and investors need to know what to look for.
Understanding Share Dilution
Share dilution is the decrease in the value of existing shares due to an increase in the number of shares available. This closely compares to printing more money. When more money is printed and put into circulation, the value of each unit decreases. Similarly, the more shares offered decreases each share’s worth.
Let’s say you invest in a new start-up company. You purchase 20 shares of the 100 shares available. The business is doing well, but it needs more capital so it offers an additional 100 shares to the public.
As a result, you still own 20 shares, but instead of owning 20% of the company, you now own 10%.
Why Do Companies Dilute Shares?
Dilution is when a company issues shares in addition to what is already offered. While the average person may not care about their shares losing voting power, it negatively affects their position. Here are a few reasons why a company would still want to offer additional shares.
The company may want to expand, pursue a project, or add inventory. If they don’t have enough money for new opportunities, they may issue a secondary offering issuance. These shares are added in addition to the original shares that were offered. Typically, the shares are available to new investors or for current investors.
A company could also fund its capital needs with convertible securities. The company sells these securities to investors as a type of debt that is converted into shares. With convertible securities, the shares are not initially diluted as the holder of the security determines when to convert them into shares.
Merger or Acquisition
Another reason a company may issue shares is when the company decides to carry out a merger or acquisition. Often the company decides to offer new shares directly to the acquired business’s shareholders as a payment method.
Employee compensation is another reason for diluted shares. Sometimes a company offers employees stock or stock options (instruments that are converted into stocks in the future) as part of their compensation. This leads to sharing dilution because it boosts the total share count when the employee exercises their options.
What Are the Effects of Dilution?
Most existing shareholders will not agree with the process because the more shares added to the pot, the lower the percentage of ownership for shareholders. The added shares also mean more investors are laying claim to the company’s profits.
Another negative side effect of sharing dilution is it affects the shareholder’s voting rights, giving larger shareholders an advantage over those that own a smaller portion of the company.
But it’s not all bad. For example, if the company offers new shares to increase revenue, it could positively affect all shareholders, including the existing shareholders. Even though their percentage claim over the company’s earnings goes down, the size of the profit pie increases. This increase means that the original shares that were purchased are now worth more.
So if a company properly manages the money received from a share issuance and achieves a high enough return on equity, the impact of share dilution is offset.
What Are the Warning Signs of Share Dilution?
Share dilution is not always predictable, and because the dilution results in a reduction of an individual investment, it is important to be aware of the warning signs. There are many reasons why a company would need an equity capital infusion.
One scenario could be that the company does not have enough capital to maintain profitability and cannot take on debt due to existing debt covenants. Additional shares could be the necessary option.
Investors should look out for companies offering large amounts of their employee’s stock options. The shares will be significantly diluted when employees exercise their options. Often, companies require key employees to disclose when and how much they expect to exercise their optional holdings.
Finally, watch for a company looking at growth opportunities. This could be to acquire an existing company or to expand the existing company with a new project. These opportunities require additional funding, so a very common way for a company to attain the funding would be to offer additional shares, ultimately resulting in share dilution.
Diluted Earnings Per Share (EPS)
Investors want to understand the impact of the value of their shares if all convertible bonds or convertible preferred shares are executed. This is because it reduces the earning power of each share and lowers the voting power of the investor.
To understand the impact, you must figure out the earnings per share (EPS). You take the net income and divide it by the number of shares to calculate the earnings per share.
Basic EPS does not include the dilutive securities and their effects. It is just a snapshot of the total earnings and weighted average of the outstanding shares in that period. A company’s diluted EPS will be the same as its basic EPS if there aren’t any potentially dilutive shares.
So How Is Diluted EPS Calculated?
Diluted EPS is the value of each share if all possible convertible securities are exercised at the earliest point in time and converted into common shares.
This includes stock options, convertible debt, and warrants. This is calculated by subtracting the preferred dividends from the net income and dividing it by the average outstanding shares plus the dilutive securities.
Diluted EPS = Net Income - Preferred Dividends / Average Outstanding Shares + Dilutive Shares
You’ll calculate and report these numbers in the financial statements provided by the company.
Financial Statements and Diluted EPS
Publicly traded companies must update their investors, customers, and other interested parties periodically. While smaller companies are not regulated, they provide financial statements like the larger publicly traded companies.
These statements provide key line items to use when analyzing dilution effects like the basic EPS and the diluted EPS. They may also include the diluted weighted average shares along with the weighted average shares outstanding.
It is also important to note what details the company provides in the footnotes of the financial statement. This could include specific details regarding what has been offered to executives or other employees regarding stock options and what effects they have on the reported results.
The Bottom Line
Overall, it is incredibly important for investors to understand the impact that dilution has on the value of their portfolios and voting power. To succeed, the company must properly manage and adjust its earnings per share and ratios for its valuation when diluting shares. Investors must keep their eye out for any possibilities of share dilutions and their impact on their share percentage and their investment as a whole.
It is difficult to decide on the best way to raise equity without dilution, but it often feels like the only option. With Ampla, diluting your equity doesn’t have to be the only option. Ampla offers tech-enabled financial solutions to help a variety of brands grow. Leverage our funding today, and eliminate the need to resort to sharing dilution.