Guest blog post by Nikolai Vassev from Smart Money Gains
When a company issues additional shares of its stock, it effectively reduces the value of existing shares’ proportion of ownership in a company. Practically every company dilutes is shares whether for organic growth, financing acquisitions or for compensation purposes. The impact of dilution on shares isn’t immediate and not always bad but gradual dilution over time does tend to erode value for investors.
This is why it is important for investors to understand and be wary of companies that are excessively diluting their shareholders and to be able to spot when this is occurring.
Understanding Dilution
Share dilution happens when a company issues additional stock meaning that an investor’s ownership in the company is reduced, or diluted when these new shares are issued.
Assume a business has 100 shareholders and that each shareholder owns one share, or 1% stake in the company. Assume the company issues 100 new shares and there are now 200 outstanding shares. Each original investor now owns 0.5% of the company because the ownership has been diluted by the newly created shares.
How to Spot Dilution in Charts:
- High days are progressively achieving a lower price per share
- Low days are progressively achieving a lower price per share
- Volume shows a progressive trend upwards to achieve the same price per share as it did with significantly less volume earlier.
When Dilution is actually a good thing
A company is able to sell more shares to fund its operations, working capital, pay debt, acquire assets and recruit top talent vis stock options. Many microcap companies are particularly fond of dilution because they may not have much cash to compensate executives or to acquire assets, but the companies are able to offer their shares as currency to help grow their business.
Examples of Stock Dilution
Aurora Cannabis ( NYSE: ACB ) has quickly become a cannabis powerhouse but is guilty of continuously diluting their shareholder base. The company’s share count has skyrocketed from 313 million shares in 2017 to more than 1 billion shares today. The company has been able to grow by acquiring 15 other companies in 3 years. But using money it didn’t have to buy $3.7 Billion in assets last year Aurora saw it’s stock dropped 35% in 2018.
One problem that the company will face is a very low earnings per share number and potentially several asset write downs from bad deals. With more shares outstanding the net income will yield a smaller earnings per share and will increase the company’s P/E Ratio.
The orange line reflects the stock performance would have been without dilution.This is just a visual example to show the effects of it in a literal sense. It is clear that the company would not have reached the same level of prominence without some dilution, the question here is did they dilute too much?
Bottom Line
Inexperienced investors often don’t understand the detrimental effect that newly issued shares can have on a stock. It is important to be vigilant of companies issuing a massive number of shares into the market as it can mean a big drop in equity for investors. If this practise is not reigned in by management and the share float increases to unsustainable levels many stocks can become worthless along with your hard earned dollars.
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