When a company issues additional shares, it affects both the existing shareholders and the new shareholders in terms of how the value of their shares may change. Depending on the issuing price of the new shares as compared to the current value of the stock, adding more shares may increase, maintain constant or decrease the value of a company’s stock. As a result, such a value change can have opposite effects on the share value for existing and new shareholders.
A company is more likely to issue new shares when its stock is overvalued so that it can receive more money for each share sold. Positive investor sentiment for overvalued stocks may allow a company to set the issuing price even higher than its stock’s current market price. When new shareholders have paid more than the stock’s original value as assessed by the stock’s existing shareholders, the difference in value may be redistributed between new shareholders and existing shareholders, decreasing the holding value for new shareholders and increasing the holding value for existing shareholders. As a result, there is a value concentration, or increase, in the company’s stock.
Depending on market conditions and investor demand, a company of overvalued stock may decide to price its new shares at par with its stock’s current market price. The capital raised from the new share issuance increases the total market capitalization of the stock, but the value of the stock per share remains unchanged. As new shareholders have paid a fair value for the stock, there is no value redistribution to existing shareholders. As a result, the new share issuance didn’t affect the value of the stock, and was a value neutral event.
New share issuance can also dilute a stock’s value sometimes if a company values its new shares at below its stock’s current market price. Such a deviation in valuation can happen in certain mergers and acquisitions in which an acquiring company offers its shares for the exchange of a target company’s shares. The acquiring company tends to overvalue the target company when such an incentive often helps gain merger approval by shareholders of the target company. Thus, the more undervalued the acquiring company’s shares are, the less value the merger brings to the acquiring company’s shareholders on a per share basis, diluting their stock value.
Regardless of how new share issuance may affect the value of stock, adding more shares immediately dilutes a company’s earnings on a per share basis, which may have a negative effect on the value of stock in the short term. Even though fresh capital from new shares increases a company’s total shareholders’ equity value, it may be some time before the additional equity capital could have a positive impact on the company’s earnings. In the meanwhile, existing shareholders have to share the current earnings with new shareholders, decreasing earnings per share (EPS). With a lower EPS, applying a same price-to-earnings ratio results in a lowered value for the stock.
- The Motley Fool: Foolish Fundamentals -- Stock Dilution
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An investment and research professional, Jay Way started writing financial articles for Web content providers in 2007. He has written for goldprice.org, shareguides.co.uk and upskilled.com.au. Way holds a Master of Business Administration in finance from Central Michigan University and a Master of Accountancy from Golden Gate University in San Francisco.