by elmads

Investing our hard-earned money in the stock market via owning shares of publicly traded companies, are one of the ways to make our hard-earned money work for us. There are two ways to get those returns in the equity markets, it is through capital gains (the increase of a company’s stock price) and dividend gains (the portion of the company’s earning in a certain time period, distributed to its shareholders).

I still remember the joy of receiving my first dividends back in 2013 like it was yesterday, despite the miniscule gain I got from my shares of a specific company that time. It was only 16.20 PHP approximately 0.25 GBP, but I knew it was a start of something new.

If you’re not familiarized yet with dividends, I’ve made written an article about it titled “What Are Dividends?”.

Additionally, my first capital gain was when I sold one of my shares that I accumulated from 2013 to the 2nd quarter of 2014, which I subsequently sold in the 3rd quarter of 2014 with a 19.11% gain. It was surreal for me that time, as I was able to get money without doing any physical labour at all.

This opened up my mind, that there are certainly ways to make money without requiring my body to work. Nonetheless, It is not always unicorns and rainbows as I eventually encountered multiples ways how to lose money, and to my surprise it was a lot more than the means of making money in the markets.

Don’t Invest directly in Stocks as a Beginner, Only If. . .

Analysing companies, the microeconomics of their business and their business model are integral to understanding a lot of things in the company. This approach helps mitigate the risks of poor portfolio performance and a permanent capital loss.

There are a lot of red flags that can signify that a business is not a good investment, and most investors rely on their chosen strategy, circle of competence and investment metrics to build their own checklist. But there is this one part of a company that most investors commonly overlook, and this is share dilution. It is one of the notorious silent killers of most investors’ returns.

Share Dilution

To understand what it is, we’ll first need to break down the meaning of each word.

“Share”, it is an asset which signifies an investor’s piece of ownership of a certain company, while “Dilution” is an action of making something weaker in force, content or value. Combining the two words give us “Share Dilution”. It is the act of reducing the value of an investor’s shares held within a corporation.

Before I move forward to discussing this further with examples, I highly suggest for you to understand and read my two blogs about “Stocks & Shares” & “How Shares are Made and How the Stock Market Works”. This will give you the basics of Shares and how it is made, and will further help you understand share dilution.

Equity Financing

Businesses usually have 3 ways to raise capital, either through their retained earnings (their accumulated earnings since day 1 of the business), Debt Financing (taking on debt) and lastly Equity Financing (The management issues more shares of their company for investors/traders to purchase it, in exchange for money).

Raising Capital, A Story

The latter part is where we will focus because this is where share dilution happens, most especially with publicly traded companies.

The Three Ways on how Companies Dilute your Shares

1.) Secondary Offering, like Stock Rights Offering (SRO) – An existing publicly traded company will offer more shares of their firm in exchange for money. This is one of the ways for them to raise capital, through equity financing. The proceeds of the said secondary offering is usually used for expansion purposes (new products, new technology, geographical expansion, acquiring another company, merging with another company ,and for paying off their debts).

To give you context, see articles below:

• UnionBank of the Philippines buying Citibank’s consumer banking division in the Philippines

UnionBank did not use their own accumulated earnings (retained earnings of the company), nor took on debt to raise that $1.1 Billion to acquire Citigroup. Instead, they took the path of equity financing, where they sold more shares of company to their existing shareholders.

In the point of view of the shareholders: if they bought the additional shares equal to the amount of their existing held shares, then basically they’ll not lose the total percentage they own of the business. Whereas, if they did not take the deal, then they’ll have less percentage shares owned of the business, and in turn they’ll receive less dividend per share in the future.

• Globe telecom Stock Rights Offering

Same as with the UnionBank’s SRO example above, Globe will undergo the same method, the only difference is the purpose of raising money. Unlike UnionBank, where they raised capital to acquire an existing business, Globe Telecom will be using the proceeds for debt servicing (paying off their existing principal and interest on an outstanding debt).

2.) Employee Stock Options (ESO) – This is one of the ways companies incentivize their employees to work well and also work for them for a longer time. This is not a direct stock given by the company to their employees, instead what the firm gives is the rights to buy the company’s stock at given time and price in the future.

Let me explain this further with a scenario:

We have a sample public company named “Numerals co.” and its current stock market price is at $50/share. The board of directors of the company hires a new CEO to run the business. The deal they had with the new CEO are as follows:

• Salary = “x” amount per year
• The new CEO can purchase 5,000 stock options which he can purchase for a period of 1 year at $50/share, starting in 2 years.

So, how will the newly hired CEO be incentivized to do well?

What would happen here is the CEO will need to work hard and smart to grow the business, its earnings for a couple of months and years, and let the stock price reflect the growing business.

If the CEO becomes successful with his/her plans for the business, then the current stock price of the company at $50/share could go to $60, $70, $80, $90, $100 per share or more, depending how investors will be willing to price and value the company based on its current to projected business performance.

With this in mind, if the stock price goes up, then the CEO could take the stock option and realize it into a proper stock holdings of the company worth $50/share (as stated in the stock option contract above) and sell it at a higher price, once the stock price of the company goes up (only if the CEO runs the business well and if the markets see its relative value to the performance of the overall business).

The catch here is, the CEO only has 2 years to realize the stock option, if the stock price stays flat, or worse go to the opposite direction within the given time period, then the CEO would not be able to get that added monetary opportunity via the stock option granted to him by the board.

To put it simply, in a child level. It is like a kid asking for a pair of Nike Jordan from his/her parents. The deal is, the kid’s parents will give him/her what he/she wants as long as the kid will be able to achieve good to high grades at the end of the school year.

Regardless of the outcome of the deal, the kid will still receive a pocket money for school from her parents (salary). It’ll then be up to the kid if he/she will do his/her best to get good grades at the end of the year, and in turn his/her wanted Nike Jordan sneakers.

Furthermore, some companies offer Employee Stock Options (ESO) to their employees as a bonus and reward for their magnificent work. Some ESO are priced below the current stock price of the company. This will further incentivize employees to do well at work. Who wouldn’t want to receive free shares of the company way below its current trading value, isn’t it?

So, how does this dilute the overall shares of the company? It’s when the employee realizes the option, by taking on the actual stock option deal given to him/her by the company. That’s when the company will shell out additional shares for the employee who realizes his/her stock option. This in turn increases the amount of shares outstanding of the company in the market, in short, SHARE DILUTION.

NOTE: OPTIONS TRADING is a part of the financial markets under the “Derivatives Market”. It is a financial instrument in which two parties contractually agree to transact an asset at a specified price before a future date. This is an advanced and complex investing and trading method.

3.) Stock-for-Stock Merger – A company that plans to acquire another company usually offers newer shares to the current shareholder that it will be purchasing.

What may happen in such acquisition through merger of shares. The ACQUIRING company, let’s say Company A, will be purchasing all of the shares of the TARGETED to be bought company, let’s say Company B for a proposed computed price based on equity of both companies. If the shareholders of Company B agrees with the deal, then Company A will need to issue additional shares and give it to the shareholders of Company B as payment, giving them now the rights to hold an equal amount of company A’s shares and be its shareholder as well.

In a nutshell, Company A (acquiring) will give out additional shares of their company to give it to the shareholders of Company B (targeted to buy) as a means of payment to acquire Company B. Then the previous shareholders of Company B is now the shareholders of Company A after the merger.

This additional shares will further increase the outstanding shares of the company, which will dilute the shareholders pre-merger.

What happens to your shares when it gets diluted?

Your piece of ownership of the company reduces, and so as the dividend amount you’ll be receiving, only if the company pays one. Remember, what we own in the company are its earnings, and sometimes the earning of the company are given to us through dividends.

Let me give you an analogy via a pizza illustration.

As shown in the infographics above. The more shares that a public company gives out to the public markets, the lesser the ownership of an existing shareholders will have on a company’s earnings.

BONUS CONTENT – Stock Splits

There is this confusion regarding Stock Splits. Most people think that this is also a share dilution of sort, when if fact it is not.

Stock Split, same as share dilution, has something to do with the total shares outstanding of a company. It is true that the shares of a company that undergoes a stock split will substantially increase its number of shares, which can be bought, sold and held in the stock market. However, unlike share dilution where: your number of shares held doesn’t change.

For instance; you currently own 10 shares of a business, and the business’ total shares outstanding pre-dilution is 1,000,000, then let’s say a dilution occurs. In this scenario, you’ll still own 10 shares of the business, but the total shares outstanding of the company increased to 10,000,000. The total company shares outstanding grew 10 times, whereas your number of shares still stayed at 10 and didn’t change at all.

In stock splits, the number of shares held of the current shareholders will also increase in line with the total shares outstanding increase. For example; a company will under go a stock split. Before the stock split occurs, you own 10 shares of the company that has a total shares outstanding of 1,000,000. Then post-stock split, you’ll now then be owning 100 shares, while the company’s total shares outstanding will be at 10,000,000. Both your held shares and the shares outstanding of the company increased by 10 times. This is an example of 1:10 stock split, also called as 10-for-1 stock split.

To make this more understandable, let’s use the most recent stock split done by Amazon, where they did a 20-for-1 stock split.

What happened here is that if you own 1 share of Amazon before the stock split, you’ll now then be owning 20 shares of Amazon after the split. A surprising turn of events isn’t it? well nothing actually changed, because your previously 1 share of Amazon was just broken down into 20 share. While the ownership percentage you have of the company is still exactly the same. This is because the outstanding shares of Amazon being traded in the market were also divided into 20 pieces.

A stock split does not impact a company’s market capitalization, the combined value of all its shares, and it doesn’t change the value of each investor’s stake in the company. It merely increases the number of shares outstanding and decreases the cost of each share.

For what reason you asked? for it to be more affordable to purchase a share of a company, because in a stock split, the market prices goes down in line with the increase of the total number of shares.

Let’s go back to Amazon, a day before the stock split happened, the stock price of Amazon was at $2,785.58/share, then the day after the stock split, it went down to $139.28/share.

The $2,785.58/share was divided by 20 which gave the $139.28/share. Then the total number of shares was multiplied by 20. And as you can see, it was hard to purchase just a share of Amazon at $2,785.58/share for ordinary citizens, but due to the stock split, it is now easier to purchase one full share of Amazon at only $139.28.

Stock Split doesn’t dilute shareholders, instead it is done for the sole purpose to make it easier for both potential and existing shareholders to purchase shares of the company.

Below is the historical stock splits that Amazon has done through its business lifetime.

To Sum It Up

Share dilution is a significant threat to an equity investor’s potential return, and only a few is aware of this. We shouldn’t just bat an eye on it, instead we should always include this in our investment analysis.

All employee compensations such as Employee Stock Options (ESO) are also called Stock Based Compensation. This can be found on a company’s financial statements under cash flow statement and sometimes in income statement.

Below is the 2021 Cash Flow Statement of Apple Incorporation.

Additionally, all public companies’ total shares outstanding can be located on their financial reports.

A company may grow in an above average manner compared to its peers in the industry, but if they continuously dilute their shareholders in a substantial amount and in a yearly basis, then it could yield poor long-term returns for its investors.

Just think of it as like this, a fast growing company will make you happy thinking that you made a wonderful investment decision, but underneath all of it, is a yearly declining ownership percentage you have of its fast growing earnings. 😔

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.