Stock dilution
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Stock Dilution results from the issue of additional common shares by a company. This can result from a secondary offering, from employees exercising their stock options, or by the conversion of convertible bonds, preferred shares or warrants into stocks. There are three issues.
- The ownership percentage or voting control may be reduced.
- The per-share-earnings of the company may be reduced when shared among the greater number of shareholders. This depends on the proceeds received by the company and the return realized on its investment.
- The value of an individual's share of the company may be reduced. Again this depends on the proceeds. This value can be a measure of the owners's share of the underlying business. Or it can be a measure of the stock's value in the secondary market. Some say dilution has the technical meaning of an event that reduces an investor's stock price below the initial purchase price, without regard to the exact ownership percentage.
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[edit] Control dilution
In many venture capital contracts there is in antidilution provision in favor of the original investors, to protect their equity investments from dilution. One way to raise new equity without diluting voting control is to give warrants to all the existing shareholders equally. They can choose to put more money in the company, or else lose ownership %. When employee options threaten to dilute the ownership of a control group, the company can use cash to buy back the shares issued.
The measurement of this % dilution is made at a point in time. It will change as market values change. It cannot be interpreted as a measure of the impact of dilutions.
- Presume that all convertible securities are convertible at the date.
- Add up the number of new shares that will be issued as a result.
- Add up the proceeds that would be received on these conversions and issues. (The reduction of debt is a 'proceed').
- Divide the total proceeds by the current market price of the stock to determine the number of shares the proceeds can buyback.
- Subtract the number bought-back from the new shares originally issued
- Divide the net increase in shares by the starting # shares outstanding.
[edit] Earnings dilution
The calculation of earnings dilutions derives from this same process. The net increase in shares (steps 1-5) is determined as of the beginning of the reporting period, and added to the beginning number of shares outstanding. The Net Income for the period is divided by this increased number of shares. Notice that the conversion rates are determined by market values at the beginning, not the period end. The returns to be realized on the reinvestment of the proceeds are not part of this calculation.
[edit] Value dilution
This analysis presumes that the company can put to work the proceeds received at a rate of return equal to the pre-existing business. When shares are issued in exchange for the purchase of a business, the incremental income from the new business must be at least the ROE of the old business. When the purchase price includes goodwill, this becomes a higher hurdle to clear.
Owners' share of the underlying business. If the new shares are issued for proceeds at least equal to the pre-existing book value per share, then there is no dilution in value. The old owners own a smaller piece, but of a bigger company. This still leaves the question "did the old owners receive full value?".
Market value of the business. Quite frequently the market value for shares will be higher than the book value. Investors will not receive full value unless the proceeds equal the market value. When this shortfall is triggered by the exercise of employee stock options, it is a measure of wage expense. When new shares are issued at full value, the excess of the market value over the book value is a kind of internalized capital gain for the investor. He is in the same position as if he sold the same % interest in the secondary market. To see this work consider this | example.
Assuming that markets are efficient, the market price of a stock will reflect these evaluations, but with the increase in shareholder equity 'management' and prevelance of barter transactions involving equity, this assumption may be stretched.
[edit] Impact of preferred share dilution
Preferred share conversions are usually done on a dollar-for-dollar basis. $1,000 face value of preferreds will be exchanged for $1,000 worth of common shares (at market value). As the common shares increase in value, the preferreds will dilute them less (in terms of %ownership), and vica verca. In terms of value dilution, there will be none from the POV of the shareholder. Since most shareholders are invested in the belief the stock price will increase, this is not a problem.
But when the stock price declines because of some bad news, the company's next report will have to measure, not only the financial results of the bad news, but also the increase in the dilution %. This exacerbates the problem and increases the downward pressure on the stock, which increases the dilutions, etc, etc. Some financing vehicles are structured to augment this process by redefining the conversion factor as the stock price declines. Thus leading to a "death spiral".
[edit] Impact of options and warrants dilution
Options and warrants are converted at pre-defined rates. As the stock price increases, their value increases dollar-for-dollar. If the stock is valued at a stable P/E it can be predicted that the options' rate of increase in value will be 20 times (when P/E=20) the rate of increase in earning. The calculation of "what % share of future earnings increases goes to the holders of options - not shareholders?" is [1]
(in-the-money options outstanding as % total) * (P/E ratio) = % future earnings accrue to option holders
E.g. if the options outstanding equals 5% of the issued shares and the P/E=20, then 95% (= 5/105*20) of any increase in earnings goes, not to the shareholders, but to the options holders.
