Understanding Stock Dilution

Understanding stock dilution

Most companies are divided into shares – portions of the company with equal value. The company may be made up of 10 shares or 10 million. This is to spread ownership of the company and its assets over a group of people. The fewer the shares the more equal the ownership is. For example if there are 2 shares, each owner has 50% of the shares. If a company has 100 shares, this allows for potentially one owner to have 51 shares and the other own 49, or more than 2 owners to own a mix of shares.

Shares are issued at specific times during a company’s life. When the company is starting up, the founding owners have shares usually to mirror their level of investment. Later on, if the company needs more capital for operations or other activities, it sells additional shares. If the company goes public, more shares may be generated to help raise additional funds through stock sales on the stock market.

Also if a company grows, it may experience stock splits. This is when the stock price is seen as being too high, and each existing share is split into 2 or more new shares each with an equal part of the original value of the original share. For example if a company has 100 shares each worth $100 and then splits the stock into 300 shares, each new share is worth $33.33. This also means that each stock holder now has three times the shares. The idea behind a stock split is that it’s easier for lower priced stocks to increase in value and it increases the volume of sales.

Any time additional shares are added or split or created in a company, it dilutes the original shares value. Stock splitting allows the stockholders to maintain their value, just spread over more shares. The other methods may introduce stock to the company effectively diluting the value of the original shareholder’s stock. For example if a company has 100 shares, and just creates another 200 shares to sell on the open market, each of those original shares is now worth 33.33% of what it was before. This dilutes the stock value.

It should be apparent that there are two groups involved in stock dilution- the company, and the shareholders. From the company’s point of view, diluting the stock doesn’t matter because it will get the money raised from the sale of new stock directly. In fact this method is better than splitting stock, because the company won’t see any new capital raised from a stock split until the stock goes up in value and the company sells any shares it holds. From the shareholders’ point of view, if the company creates new stocks to raise capital, it makes their shares worth less than they were before and this is not preferred. For shareholders, stock splitting is much better as it keeps the same amount of value with each shareholder, even though the shares are diluted or devalued.

This concept is the same as with a country’s economy. Each country can print its own money. The money they have right now is valued based on what the country’s assets and debts are seen to total. If that country begins to print more money, then the value for each dollar or unit of currency goes down because the value is spread out thinner. When this happens, it takes more dollars to buy something. For example a loaf of bread that used to cost $1 may now cost $3. This devaluing of currency greatly affects inflation.

So stock dilution is generally good for a company, but can be undesirable for stock holders depending on the method of dilution.