What Causes Dilution?

How Dilution Affects Stock Price

Stock Dividends and Splits.

Dilution increases the number of shares outstanding, which reduces earnings per share and each shareholder’s percentage ownership. Employee stock options are one type of security that can potentially dilute a company’s shares. An option gives its holder the right to buy stock from a company at a predetermined price. While dilution from conversions and stock options certainly hurts EPS and thus stock price, a company may use new shares to finance the takeover of another firm. As long as the acquiring company doesn’t overpay for the target, the acquired net assets, employees and operations add value to the acquirer commensurate with the amount of stock dilution.

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Stock dilution, also known as equity dilution, is the decrease in existing shareholders’ ownership of a company as a result of the company issuing new equity. New equity increases the total shares outstanding which has a dilutive effect on the ownership percentage of existing shareholders.

What effect do options have on the number of stock shares a company has in circulation? The answer can make a big difference when a company computes its earnings per share, and when investors calculate the critical price-to-earnings ratio.

Core , professor of accounting at Wharton, and S. The paper was published in The Accounting Review in July , and has special relevance now because regulators such as the Financial Accounting Standards Board are expected to modify options accounting rules next year. Understating dilution inflates earnings per share, the authors say.

Employee options give their owners the right to buy shares at a set price anytime over a given period. The right to exercise the options may vest all at once or in stages on the first few anniversaries of the grant. Employee options usually expire if they are not exercised within 10 years. Options appeal to employees because they can convey great value without requiring that the employee put money at risk, as one does owning actual shares of stock. By , that figure had grown to 8. The growing use of options has raised a debate about how they should be accounted for.

Some advocate carrying them as an expense, arguing options have value and should be considered a compensation cost just like wages and other benefits. This issue has received a great deal of attention in the past few years, and the FASB expected to issue new rules in requiring some form of expensing. But this still leaves the second problem of how to account for options-related dilution of share value, Guay and his colleagues say. However, the cash received in exchange for the new shares increases the assets of the company.

If the cash is used in ways that do not increase earnings, such as lavish executive compensation or golf junkets, existing shareholders will lose part of their ownership stakes and suffer lower stock prices without benefit.

A company can fight dilution through a share buyback program, in which the corporation buys up shares on a stock exchange at current market prices and retires the shares, removing them from the float. Buyback programs are designed to raise stock prices by cutting the number of shares claiming a portion of earnings. Another tool to fight dilution is to issue convertible securities with call provisions, which are options that give the company the right to force investors to sell their convertible securities back to the company for a specified price, thereby cutting potential dilution.

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This generally occurs when shares are issued in exchange for the purchase of a business, and incremental income from the new business must be at least the return on equity ROE of the old business.

When the purchase price includes goodwill, this becomes a higher hurdle to clear. The theoretical diluted price, i. If the new shares are issued for proceeds at least equal to the pre-existing price of a share, then there is no negative dilution in the amount recoverable. The old owners just own a smaller piece of a bigger company. However, voting rights at stockholder meetings are decreased. But, if new shares are issued for proceeds below or equal to the pre-existing price of a share, then stock holders have the opportunity to maintain their current voting power without losing net worth.

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.

Assuming that markets are efficient, the market price of a stock will reflect these evaluations, but with the increase in shareholder equity 'management' and prevalence of barter transactions involving equity, this assumption may be stretched. Preferred share conversions are usually done on a dollar-for-dollar basis. As the common shares increase in value, the preferreds will dilute them less in terms of percent-ownership , and vice versa. In terms of value dilution, there will be none from the point of view of the shareholder.

Since most shareholders are invested in the belief the stock price will increase, this is not a problem. 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 percentage. This exacerbates the problem and increases the downward pressure on the stock, increasing dilution. 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 ".

Options and warrants are converted at pre-defined rates. As the stock price increases, their value increases dollar-for-dollar. The calculation of "what percentage share of future earnings increases goes to the holders of options instead of shareholders?

A share dilution scam happens when a company, typically traded in unregulated markets such as the OTC Bulletin Board and the Pink Sheets , repeatedly issues a massive number of shares into the market using follow-on offerings for no particular reason, considerably devaluing share prices until they become almost worthless, causing huge losses to shareholders.

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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 percentage.

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They can choose to put more money in the company, or else lose ownership percentage. Options and warrants are converted at pre-defined rates.

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