Oct 17, 2022 Value Broking 5 Mins 1.8K

Share dilution meaning: Share dilution or equity dilution is a situation that occurs when a company issues additional stock. Because of the addition of new stocks, the shareholder stock price gets reduced or diluted when the equity dilution happens.

In simple words, equity dilution means that when a company issues a new group of shares, it can reduce the value of existing shares owned by different investors. This overall process is called equity dilution. Most commonly, the equity dilution poses a high risk for shareholders and directly affects the company’s share price. 

For a small company, stock dilution means a business with ten shareholders, and each shareholder owns one share or 20% of the company. If each shareholder receives voting rights, then the control of the shareowner will be around 20% in the company decision.

And if the company has issued just 20 shares and a single investor buys all the shares. Then the single investor will become the owner of 20 shares and 50% of the company. Due to the issue of new shares, the original investor can own just 5% of the company. It is around 5% of the company as one share because of the diluted new shares.

Most of the time, the number of shares is large and rarely a case where individual investors invest and get to own half of the company. For example, let us assume that A company, ABC, has issued 100 stocks, and a person named Akash buys around 50 stocks. It means that Akash is the 50% owner of the ABC company. But if the company decides to raise another 100 stocks for any particular reason. Then Akash, who has 50 shares and was a 50 % owner of the company, will decrease the value of his stocks to about 25 % ownership in the company.

There are numerous reasons for stock dilution. However, the most common of them are:

  1. Companies need to add cash to the balance sheet.
  2. Raising capital for expansion or growth of the business.
  3. Merging with another company.
  4. Covering debt.
  5. Covering employee stock options that got awarded to them.
  6. Other strategic plans.

How Does Stock Become Diluted?

The stock is diluted when there is the conversion of stocks by any holders. For example, different holders such as employees or board members have stock under their ownership. These types of stocks can be converted to general shares and result in more shares in the stock market.

Share dilution can reduce the value of the individual investment; common investors must be aware of the warning signs that indicate the potential equity dilution; such events are emerging and need to be managed before facing any risks.

You can see this situation when a firm looking for capital growth or clearing its debt will issue additional stock dilution. To know the value of a diluted share, you can follow a formula that calculates. First, all the convertible securities will be converted to the common shares or diluted earnings per share (EPS). You can calculate the EPS through a company financial statement and accurate data.

Diluted EPS = Net income – Preferred Dividends / WA + DS.

Meaning:

WA means the weighted average shares outstanding.
DS refers to the conversion of dilute securities.

Well, the basic EPs do not include the effect of dilutive stocks. The formula measures the total earnings by the weighted average shares. Suppose a company did not have any potentially dilutive share, then its basic EPS would be the same as its dilutive EPS.

Effects of Share Dilution

As we know, what is stock dilution? We understood the effect of share dilution. An equity dilution is not a good sign for your investments. 

The stock dilution process makes the company own a tiny piece by adding more stockholders. In many cases, large stock owners often take advantage of shareholders that own a smaller part of the company.

You can say that share dilution is always a bad step. There are chances of stock volatility, but the stock price can rise and turn itself into a better investment choice as a reason for capital gains. For many firms, stock dilution is better than taking any other debt or taking funds from other firms. 

A Stock option and shares come with a vesting period. This vesting period comes within a few years. It can result in employees leaving before the vesting period. The leading company’s employees can choose to exercise the options to convert the shares into common shares. The employee needs to disclose in their contract and follow the diluting of their holdings.

Conclusion

This article is helpful to understand stock dilution meaning. The dilution of shares occurs when a company issues more shares to achieve a strategic goal plan by the company board of directors. Dilution of shares reduces the value of existing shares and can harm the investor portfolio. Therefore, any investor must look at the sign of equity dilution. They must even consult regarding the effect and value of that share.

A company makes adjustments in its earnings per share and ratio for the valuation and dilution process. Many companies tend to make a productive move by diluting their share and planning for a company’s brighter future. A share dilution can also mean that a company will gain capital and ultimately increase the share price and the dividends in the long run. 

However, the share dilution is in the hands of the investors. An investor cannot predict or prevent share dilution. If investors want to gain an equal stake in a company, they need to buy more shares after or when the dilution happens. Buying shares will be costly, but you can gain the same ownership before the share dilution.