Dilution of shares occurs when a company issues additional shares of stock, diluting existing shareholders’ percentages of ownership in the company.
Dilution of shares reduces the value of stock held by existing shareholders, but it can have long-term benefits for shareholders. When a company issues new shares of stock to acquire another company, it may increase revenue or become more profitable.
In this article, we examine reasons why dilution of shares occurs and the potential impacts on shareholders, both pros and cons.
Definition and Example of Dilution of Shares
Dilution of shares is when a public company issues more shares of stock, which essentially dilutes the percentage of ownership held by the existing shareholders.
A person who purchases shares of stock in a company has equity ownership in that company. The total number of shares outstanding that are available for trading is known as the “public float.” If the company decides to issue additional shares of stock in a secondary offering, the float increases and the value of shares held by the initial shareholders decreases.
For example, electric carmaker Tesla has issued new shares of stock numerous times since its initial public offering (IPO) in 2010. Tesla’s capital-intensive projects have come at substantial costs, which the company funded in part by diluting shares. In December 2020, Tesla raised nearly $5 billion by issuing 2.65 million new shares. It was the third time that year the company issued new shares.
Earnings per share (EPS) reflects a company’s net income divided by the number of common outstanding shares. Diluted earnings per share factors in shares that a company may be obligated to issue in the future, such as employee stock options. EPS and diluted EPS are usually both listed on a company’s income statement.
How Dilution of Shares Works
Companies issue additional shares of stock for a number of reasons, including:
- Adding cash to the balance sheet
- Raising additional capital for growth opportunities, such as launching new products, building or expanding facilities, or expanding into new markets
- Acquiring another company
- Covering employee stock options that were awarded
- Paying off debt
To better understand how dilution of shares works, consider this example:
If company XYZ has a $1 million market capitalization and 100 investors each hold 100 shares of stock, then each shareholder owns 1% of the company, or $10,000. If the company issues another $1 million in shares, it would double its market capitalization to $2 million. The existing shareholders’ percentage of ownership then would be cut in half to 0.5%.
In the tables below, we summarize this example.
|Shareholder value and percentage of ownership before new shares are issued|
|Total market cap||$1,000,000|
|Value of shares held by each shareholder||$10,000|
|Percentage held by each shareholder||1%|
|Shareholder value and percentage of ownership after new shares are issued|
|Total market cap||$2,000,000|
|Value of shares held by each shareholder||$10,000|
|Percentage held by each shareholder||0.5%|
Issuing new shares of stock is different from a stock split. In a stock split, the share price drops, but existing shareholders receive additional shares to correlate with the new number of shares that have been created.
In a stock split, the value of shareholders’ percentages of ownership does not decrease. A company aims to take in money with a stock split. It often initiates a stock split after its share price has increased significantly and it wants to make its stock more accessible to individual investors.
Pros and Cons of Share Dilution
With dilution of shares, the value of the original shareholders’ stock remains the same (assuming the share price is unchanged), each shareholder’s percentage of ownership of the company is reduced.
Can fund growth opportunities
Potential for larger dividends
May help increase in share price over the long term
Reduced ownership stake for existing shareholders
Potential for smaller dividends
Potentially reduces earnings per share
Reduces shareholder voting rights
- Can fund growth opportunities: A company may issue additional shares to fund projects or an acquisition that will help it increase revenue.
- Potential for larger dividends: Even though there are more shareholders receiving dividends, payouts may increase as a result of increased revenue, creating higher earnings per share.
- May help increase in share price over the long term: A company that uses funds generated by issuing additional shares could potentially create long-term growth that might lead to share price increases.
- Reduced ownership stake: Issuing additional shares will reduce existing shareholders’ percentages of ownership.
- Potential for smaller dividends: Because there are more shareholders to pay dividends to, if earnings per share do not rise to make up the difference, dividend payments may shrink.
- Potentially reduces earnings per share: Because there are more shares, the company will have to increase revenue or its EPS will decline.
- Reduced shareholder voting rights: Existing shareholders’ whose percentages of ownership drop will also experience a decline in voting rights.
What It Means for Investors
In most cases, shareholders can’t prevent dilution of shares. However, every shareholder has the right to sell their shares if they view a dilution of shares as a red flag for a particular company’s financial stability.
Investors should understand the details provided by company executives as to why it is issuing new shares before they decide whether or not to remain invested.
- Dilution of shares occurs when a company issues additional shares of stock to raise money, acquire another business, or for other reasons.
- Dilution of shares reduces existing shareholders’ equity in the company, but not the dollar value of their stake.
- Shareholders will have their voting rights reduced following dilution of shares.
- Dilution of shares is different from a stock split, which is when the number of shares increases but the shareholders’ percentage stake in the company does not change.