Dilution occurs when ownership interest in a company is reduced by issuing more shares of stock.
The impact of dilution is illustrated in the supply and demand graph below. The share price decreases when the supply of shares increases.
A company’s management increases the number of outstanding shares when it seeks to raise additional capital by selling stock or when an employee or anyone else exercises stock options. (Employees are often compensated with stock options, which allow them to purchase stock at a predetermined price when exercised.) Issuing new shares reduces or “dilutes” the ownership interest of existing shareholders.
For example, imagine a company with 100,000 shares outstanding and 10 shareholders. Each shareholder initially owns 10,000 shares, representing one-tenth of the company. Suppose management issues an additional 100,000 shares, increasing the total number of outstanding shares to 200,000. If the initial shareholders do not purchase the new shares, their ownership interest would be diluted and drop to five percent. Conversely, management may buy back some shares to reduce the supply and increase the share price.
A stock split does not result in a dilution of ownership. While the number of shares increases, the price per share is adjusted so the overall ownership interest remains the same. For instance, in a two-for-one stock split, each shareholder would end up with 20,000 shares, but their ownership stake would remain 10 percent.
Typically, shareholders dislike seeing their ownership diluted because it can decrease the stock’s price, as shown in the graph above. However, it is important to note that dilution is not always detrimental to shareholders. In fact, it can be beneficial if management effectively uses the capital raised from issuing additional stock. When invested wisely, the increased profits can lead to greater demand for the company’s shares.
For instance, consider a scenario where a company generates $200,000 in income before issuing 100,000 additional shares, resulting in $2 per share earnings. If the company increases its income to $500,000 after issuing the new shares, the new earnings per share would rise to $2.50 ($500,000 / 200,000), ultimately benefiting the original shareholders.
Capital – Financing Business Growth
Understand a Stock’s Performance Using Supply and Demand
