By Mfonobong Ukpe
A common problem plaguing existing investor’s shares in a company is share dilution. This situation occurs where a given company issues additional shares and such issuance occasions a reduction of the value of existing investors’ shares and their proportional ownership of that corporation. The need for awareness of such impending risk of the proposed or existing shareholders cannot be overemphasized. Thus, it’s pertinent for investors to take a closer look at how dilution happens and understand how to protect their portfolios.
Below is an outline on the purview of share dilution and why it is important.
What Is Share Dilution?
Share dilution usually occurs when a company issues additional stock. Therefore, shareholders’ ownership in the company is reduced, or diluted, when these new shares are issued.
It is considered where a company is divided into smaller pieces, wherein the current investors or shareholders 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.
Take for instance, a company has 10 shareholders and that each shareholder owns one share, or 10%, of the company. If investors receive voting rights for company decisions based on share ownership, then each one would have 10% control.
In the event the company then issues 10 new shares and a single investor buys them all. There are now 20 total shares outstanding and the new investor owns 50% of the company. Meanwhile, each original investor now owns just 5% of the company—1 share out of 20 outstanding—because their ownership has been diluted by the new shares.
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.
How Do Shares Become Diluted?
There are several situations in which shares become diluted. These include:
- Conversion by holders of optionable securities: Stock options granted to individuals, such as employees or board members, may be converted into common shares, which boosts the total share count.
- Secondary offerings to raise additional capital: A Company looking to raise new capital to fund growth opportunities or to service existing debt may issue additional shares to raise the funds.
- Offering new shares in exchange for acquisitions or services: A company may offer new shares to the shareholders of a company that it is purchasing. Smaller businesses sometimes also offer new shares to individuals for services they provide.
Advantaged or Disadvantaged?
As earlier said, most existing shareholders don’t view dilution in a very good light, especially with the tendencies of having their ownership of the company being cut down. That may lead shareholders to believe their value in the company is decreasing. In some cases, investors with a large chunk of stock can often take advantage of shareholders that own a smaller portion of the company.
But it isn’t always that bad. If the company is issuing new stock as a means to boost revenue, then it may be positive venture. It may also be doing so to raise money for a new venture, whether investing in a new product, a strategic partnership, or buying out a competitor.
Cautionary Pre-indication of Share Dilution
Given the fact that dilution can reduce the value of an individual investment, retail investors should be aware of warning signs that may precede potential share dilution, such as emerging capital needs or growth opportunities.
A company could require an equity capital infusion for several reasons. It may simply need more money to cover expenses. In a scenario where a company does not have the capital to service current liabilities and can’t take on more debt due to covenants of existing debt, it may see an equity offering of new shares as necessary.
Emergent opportunities are another indicator of potential share dilution. Secondary offerings are commonly used to obtain investment capital to fund large projects and new ventures.
Shares can also be diluted by employees who have been granted options as well. Investors should be particularly mindful of companies that grant employees a large number of optionable securities.
If and when employees choose to exercise the options, then common shareholders may be significantly diluted. Key employees are often required to disclose in their contracts when and how much of their optionable holdings they expect to exercise.
What are Fully Diluted Shares?
A fully diluted share outstanding is the total number of shares a company would theoretically have if all dilutive securities were exercised and converted into shares. Dilutive securities include options, warrants, convertible debt, and anything else that can be converted into shares. For a financial analyst, it is important to have a solid understanding of the difference between basic versus fully diluted shares and what it means for key metrics like earnings per share.
In a typical scenario, investors may want to know what the value of their shares would be if all convertible securities were executed because doing so reduces the earning power of every share. This is called diluted earnings per share (EPS), and it’s calculated and reported in company financial statements.
Diluted EPS is considered the value of earnings per share if executive stock options, equity warrants, and convertible bonds were converted to common shares.
The simplified formula for calculating diluted earnings per share is:
Net Income – Preferred Dividends
(Weighted Average Number of Shares Outstanding + Impact of Convertible Securities – Impact of Options, Warrants, and Other Dilutive Securities)
Basic EPS on the other hand, does not include the effect of dilutive securities. It simply measures the total earnings during a period divided by the weighted average shares outstanding in the same period. If a company did not have any potentially dilutive securities, then its basic EPS would be the same as its dilutive EPS.
There some methods suitable for adoption in calculating the diluted EPS, some of which are;
If-Converted Method for Diluted EPS
The If-Converted method is used to calculate diluted EPS if a company has potentially dilutive preferred stock. To use it, subtract preferred dividend payments from net income in the numerator and add the number of new common shares that would be issued if converted to the weighted average number of shares outstanding in the denominator.
If-Converted Method for Convertible Debt
The If-Converted method is applied to convertible debt as well. After-Tax interest on the convertible debt is added to net income in the numerator and the new common shares that would be issued at conversion are added to the denominator.
However, the after-tax interest on convertible debt that is added to net income in the numerator is calculated as the value of the interest on the convertible bonds, multiplied by the tax rate.
Treasury Stock Method for Diluted EPS
The Treasury Stock method is used to calculate diluted EPS for potentially dilutive options or warrants. The options or warrants are considered dilutive if their exercise price is below the average market price of the stock for the year.
The numerator stays the same. For the denominator, subtract the shares that could have been purchased with cash received from the exercised options or warrants from the number of new shares that would be issued a warrant or option exercise, then add it to the weighted average number of shares outstanding.
Securities can be Anti-Dilutive. This means that, if converted, EPS would be higher than the company’s basic EPS. Anti-Dilutive securities do not affect shareholder value and are not factored into the diluted EPS calculation. Thus, it is pertinent to ensure that an anti-dilution clause is inserted into the Sale Shares Purchase Agreement from inception.
Assessing the Impact of Dilution using Financial Statements
Comparatively, it is simple to examine Dilutive EPS as it is presented in financial statements. Companies report key line items that can be used to canvas the effects of dilution. These line items are basic EPS, diluted EPS, weighted average shares outstanding and diluted weighted average shares. Many companies also report basic EPS excluding extraordinary items, basic EPS including extraordinary items, dilution adjustment, diluted EPS excluding extraordinary items and diluted EPS including extraordinary items.
In conclusion, dilution can forcefully wallop the value of an investors’ portfolio. The company in the circumstance must make adjustments to its earnings per share and ratios for its valuation when dilution occurs. Investors should look out for signs of potential share dilution and understand how it could affect their investment or portfolio’s value.
However, undiluted shares status can be used to secure an investors’ ownership in a company. This can be ensured by expressly stating such in the Sale Shares Purchase Agreement from inception.