Stock ownership becomes diluted when a company issues additional shares to new owners. Because there are now more pieces of the proverbial company pie, shareholders own a smaller, diluted percentage of the company. Stock values may suffer at least a short period of decline because dilution reduces the stock's earnings per share . However, most companies attempt to reinvest their new capital into improving company operations and increasing the company value. If the value of the company increases at the same rate as dilution, it may not have an adverse affect on stock prices.
Dilution can happen a variety of ways. If a company wants to finance a new project or is having trouble paying for operations, it may engage in a secondary offering. In a secondary offering, the company issues additional shares to raise capital. The company may choose to engage in a rights offering, in which it offers the exclusive rights to new shares to existing stockholders. However, most other types of secondary offerings dilute ownership and cause the stock price to suffer at least a temporary drop.
Mergers and Acquisitions
Mergers and acquisitions also can cause dilution. When a company goes through a merger, the larger of the two companies typically issues its shares in exchange for the smaller company's shares. The larger company may purchase the smaller one for more than book value due to new growth in trademarks, patents, or labor expertise that hasn't yet been accounted for. If there is a difference between the book value of the smaller company and the price the larger company paid, the stock of the larger company can become diluted.
Employee Stock Offerings
Some companies compensate high-ranking employees by offering stock options that can be exercised after a certain amount of time. The company generally issues the stock at a discounted price to provide an incentive for the employee to increase the value of the company. However, if the employee exercises his options and the company value hasn't increased accordingly, the dilution can cause the stock price to decrease.
If a company feels that its stock price is getting too high, it may purposefully engineer a stock split. A stock split doubles the amount of shares but does not change ownership. For instance, if you own 1 share worth $5 in company X and the stock splits, you own 2 shares worth $2.50 apiece. Although this reduces the value of the stock, dilution won't occur. A high-priced stock may be out of reach for some investors and companies normally split their stock to make it more affordable to the general public.
- Trading Stock Guide: Stock Dilution
- InvestorPlace: Secondary Offerings: Friend or Foe?
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- Microsoft Investor Relations. "Frequently Asked Questions." Accessed July 26, 2020.
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Based in San Diego, Calif., Madison Garcia is a writer specializing in business topics. Garcia received her Master of Science in accountancy from San Diego State University.