Dilution refers to a reduction in the ownership percentage in a certain company due to the issuance of new shares. This can happen when a company issues new stock for reasons such as raising capital, employee stock options, or convertible bonds or preferred shares being converted into stock.
Here are a few examples of how dilution can occur:
- Fundraising/Capital Increase: When a company wants to raise funds, it might issue new shares. As these new shares are sold, the percentage of the company that each existing shareholder owns decreases, even though the total value of the company may increase.
- Employee Stock Options: When a company grants stock options to its employees (which gives them the right to buy shares at a certain price), it could eventually lead to dilution when those options are exercised and the company issues new shares.
- Convertible Securities: If a company has issued convertible bonds or convertible preferred shares, these could potentially be converted into common stock. If they are converted, this increases the number of shares and dilutes the ownership of existing shareholders.
The effect of dilution on a shareholder is that it reduces their voting power. Additionally, dilution can also lead to a decrease in earnings per share, assuming earnings remain constant. However, dilution isn’t always bad. If the funds raised from issuing new shares are used effectively by the company to create higher growth, it could offset the dilutive effect and lead to an increase in the company’s overall value.
Example of Dilution
lLet’s consider a hypothetical example of dilution:
Suppose you own 100 shares in a company that has 1,000 shares of stock outstanding. This means you own 10% of the company (100 / 1,000).
Now, let’s say the company decides to issue an additional 500 shares to raise capital for a new project, making a total of 1,500 shares outstanding. If you don’t purchase any of the new shares, your 100 shares now represent a smaller percentage of the total company – about 6.67% (100 / 1,500).
So even though you still own the same number of shares, your relative ownership in the company is diluted from 10% to 6.67% because of the new shares issued. This is a simple illustration of how dilution works.
Now, if the company uses the proceeds from the additional 500 shares to fund a project that increases the company’s profits, this could potentially lead to an increase in the company’s stock price, offsetting the impact of dilution. However, if the project fails to add value, dilution might negatively impact the value of your shares.