Dilution Explained for Dummies

Specifically regarding share dilution by companies

What is share dilution?

Share dilution, also referred to as stock dilution or equity dilution occurs when a company issues additional shares, reducing existing shareholders’ percentage of ownership in the company.

The Cambridge Dictionary describes share dilution as ‘the process or action of making a company’s shares less valuable by making more shares available.’

Applying some idioms from the world of baking, share dilution can be described as follows: It is not a situation of ‘the cherry on the cake’ for existing shareholders. However, a shareholder will still get a slice of the cake – the ‘equity cake’ – albeit a smaller slice of what he or she has been used to.

What is dilution?

In general, dilution refers to the process of making something less strong by adding something to it. For instance, a concentrated liquid produced from or flavoured with fruit juice, such as orange squash or lime cordial, is diluted by adding 3 parts of water to 1 part of the concentrated liquid, making it an enjoyable drink.

Dilution of company shares operates in a similar way.

Why do companies implement share dilution?

If the issue of additional shares makes a company’s shares less valuable, why do they still execute share dilution?

There are a number of reasons why companies issue additional shares. Some of the reasons are listed below:

• Raising additional capital

Typically, this is the most apparent reason for a company to issue extra shares. New shares are issued to generate funds for further growth opportunities or to service outstanding debt.

• Acquiring another company

If a company purchases another company, the acquiring company may issue additional shares to the shareholders of the acquired company.

• Share options exercised by individuals

Companies may offer share options, also called stock options, to individuals like board members and employees. (A share option allows an option holder to buy shares in the company at a predefined amount on or before the expiry date.)

When share options are exercised, they are converted into ordinary shares of the company, increasing the number of shares.

• Conversion of convertible securities

Some companies may also issue convertible securities, such as convertible bonds, convertible preference shares, or stock warrants. Warrants are typically issued to lenders.

A convertible security is described as a security that can be converted into different security. For instance, the preference shares of a company can be converted into ordinary shares.

A stock warrant also called a share warrant, allows its bearer the right to buy a company’s ordinary shares at a certain price at a specific date.

When the owners of convertible securities exercise their rights to convert them, the number of companies’ outstanding shares increases. (Outstanding shares refer to the number of shares that a company has issued.)

• Distributing ownership

When the founders of a company reckon they own too much of a company, they can easily distribute ownership by selling a portion of the shares to new shareholders, reducing their percentage of ownership.

Examples of share dilution

• Let us say a company, in an IPO (initial public offering), has issued 100 ordinary shares to 100 individuals, now referred to as ordinary shareholders. This means each ordinary shareholder owns 1% ((1/100) x 100) of the company.

In a secondary offering, the company issues 100 additional ordinary shares to 100 new shareholders, reducing each shareholder’s ownership to 0.5% ((1/200) x 100) in the company.

• In the example below, company AJB started its operations with 200 000 shares owned by 100 ordinary shareholders. After a year of operations, the company needed additional capital to expand its operations and issued 40 000 new shares to 20 new shareholders.

The share dilution is calculated as follows:

• Before dilution
• Number of shares issued: 200 000
• Number of shareholders: 100
• Number of shares per shareholder: 2 000 (200 000/100)
• Percentage ownership: 1% ((2 000/200 000) x100)

• After dilution
• Number of shares issued: 240 000
• Number of shareholders: 120
• Number of shares per shareholder: 2 000 (240 000/120)
• Percentage ownership: 0.83% ((2 000/240 000) x100)

The effects of share dilution

• Depending on the number of shares held by a shareholder and the number of additional shares issued, share dilution can affect a shareholder’s portfolio considerably. This means each existing holder of ordinary shares owns a smaller or diluted percentage of the company.
• A company’s EPS (earnings per share) is also affected. Earnings per share (an indication of a company’s profitability) is determined by dividing a company’s profit by its outstanding ordinary shares. It is also referred to as basic EPS because it does not consider the dilutive effect of ordinary shares that could still be issued by the company.

For example, company YYY records a net income for ordinary shareholders of R755 000 and has 850 000 ordinary shares outstanding. YYY’s basic EPS is R0.89 (R755 000/850 000). After the issuance of another 50 000 ordinary shares, the basic EPS of company YYY will be R0.84 (R755 000/900 000).

However, if the share dilution causes a considerable increase in earnings, the basis EPS may not be negatively affected. If the additional capital received with the issuance of the additional 50 000 ordinary shares generates more revenue, the basic EPS may not be negatively affected. For instance, if the additional capital boosted company YYY’s revenue to R810 000, the company’s basic EPS will be R0.90 (R810 000/900 000).

Companies may also determine their diluted EPS, calculating the potential effect of share dilution if it is assumed that all ordinary shares that could be outstanding have been issued and that all convertible securities were converted or realised.

• Share dilution also reduces the voting power of ordinary shareholders because the percentage of ownership of a company of each existing ordinary shareholder decreases with the increase in the number of shares issued.
• The greater the share dilution, the more the possibility for a company’s share price to decrease. Dilution can hold share prices down even when a company’s market capitalisation (market cap) increases. (Market cap is calculated by multiplying a company’s current share price by its total number of outstanding shares.)