Dilution in Trading Definition In the realm of trading, dilution happens when a company issues new shares, resulting in the reduction of an existing shareholder's ownership percentage of the company. This phenomenon can have significant effects on both the value of individual shares and the proportion of company ownership.
Understanding Dilution A company's decision to issue new shares, also referred to as secondary offerings, increases the number of outstanding shares, also known as the "float". This expansion results in the dilution of stock, as each shareholder ends up owning a smaller, diluted percentage of the company. Consequently, the value of each individual share diminishes, lessening the stock's worth.
The Concept of Stock Ownership Each share of a company's stock signifies equity ownership in that company. The board of directors of a firm, during an initial public offering (IPO), authorizes the number of shares to be initially offered. If the company decides to issue additional stock later on, the float increases, thereby diluting the stock. This issuance means that shareholders who bought the original IPO now hold a lesser ownership stake in the company than they did before the additional shares were released.
Key Implications of Dilution Dilution essentially represents a reduction in shareholders' equity positions due to the creation or issuance of new shares. It also leads to a reduction in the company's earnings per share (EPS), which can subsequently impact share prices negatively. When a company decides to raise additional equity capital, dilution is often an adverse outcome, particularly for existing shareholders.
Understanding Value Dilution Value dilution is the diminishing value of current common stock shares due to the issuance or conversion of additional shares into the market. In essence, the value is reallocated, leading to a decrease in each share's worth, as there are now more shares dividing the same earnings amount that the company generates.
Implications of Share Conversion and Issuance When a company releases a secondary issue of shares, or if many convertible share holders decide to exercise their conversion privilege, share value dilution takes place. Similarly, diluted earnings per share (EPS) calculation shows what the EPS would be if all outstanding convertible securities issued by the company were converted simultaneously. In most cases, dilution is minor and does not cause significant concern.
The Downward Spiral of Dilution However, dilution can kickstart an inflationary spiral in certain circumstances. This situation is especially true if a struggling company issues too many shares to raise capital while its shares are being sold off and losing value. Additionally, poorly structured convertible securities could lead to a "death spiral", exposing other shareholders to an unforeseeable amount of dilution risk. If the downward pressure on the price due to short selling and conversion becomes too strong, it becomes highly challenging to halt it.
Summary
Dilution is the disassociation of value from current common stock shares due to the issuance or conversion of additional shares of the same company into the market, causing value to be reallocated.
If a company issues a follow-on (aka Secondary) issue of shares, or if many holders of convertible shares decide to use their conversion privilege, the share price will be diluted. Each share’s value will decrease because there are now an increased number of shares dividing up the same amount of earnings that the company generates.
Diluted earnings per share (EPS) is a calculation that shows what the earnings per share would be in the event that all outstanding convertible securities issued by the company were converted at the same time. In most instances dilution is minor and does not cause much trouble.
In other cases the dilution can start an inflationary spiral if a company is issuing too many shares to raise capital while the business is struggling and shares are being sold off and losing value.
A death spiral could also result from unwisely structured convertible securities which expose the rest of the shareholders to an unknown amount of dilution risk.
If short selling and conversion puts too much downward pressure on the price it’s very hard to stop it.