What is share dilution and how does it affect you?
A listed company has the option of diluting shares if it requires more funds. However, the issuance of new stock will affect both the company and existing shareholders. Discover what share dilution is and why companies do it.
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What is share dilution?
Share dilution is the reduction of the percentage of equity in a company through issuing additional stocks that’ll be put up for sale. The dilution occurs when existing shareholders’ percentage of equity in a company is reduced, enabling the freed-up stock to be used for raising capital.
Initially, the ownership of company stocks is divided among investors, and the remaining shares are reserved to be traded publicly. These are known as public float.
When listed company stocks are made available on secondary offering, the number of shares split in the company increase. Often, the funds generated are used to further the growth of the company or settle existing debt.
A recent example of stock dilution involved UK guarantor loan company Amigo. After the High Court handed down the verdict that it must raise money to settle a complaint from its customers regarding their business practices, one of its options was share dilution.
The proposed scheme was to issue 19 new shares for every existing one. This would mean that shareholders would lose 95% of the value of their current holdings. With the company not allowed to issue new loans and at risk of going out of business if it cannot raise £97 million, dilution remains the only viable option.
Amigo’s share price subsequently dropped by 60.1% as investors reacted to the proposed dilution of stocks.
Why do companies dilute shares?
- Firms opt to dilute shares to raise additional capital via secondary offering. The funds generated are directed towards growth opportunities or potentially settling existing debt
- Some companies dilute their stocks to introduce new shareholders into the holdings as a trade-off for acquiring the firm
- Staff or the board may be granted securities that could be converted into shares of common stocks
- Dilution has the potential to lead to higher dividend payouts despite the addition of more shareholders – this depends on how the company uses the capital raised and its success over a long-term period
- A company may dilute its shares as a consequence of meeting certain criteria stipulated by compliance, to raise valuation or qualify for a particular benefit
How does stock dilution affect shareholders?
Shares are a claim on a company’s equity – if more shares are issued, the existing shareholder’s ownership of the company will be reduced as a consequence. This means two things: fewer voting rights and possibly decreased dividends (in the short term, at least).
Share dilution and voting rights
As an investor, your stake in a company represents your voting power in deciding the direction that the business will take. The more shares you own, the greater your veto power. When your percentage of stock ownership in a company decreases, the voting power diminishes as the number of shareholders increase.
Share dilution and dividend payments
With more shareholders added to the company, the payment of dividends will be split even further and awarded according to your share percentage. For existing shareholders, earnings per share (EPS) will decrease if number of shares increased and the revenue will remain stable.
How does share dilution affect share price?
Share dilution can cause significant changes to the company’s short - and long term performance. The positive or negative consequence of dilution depends largely on how the market views the company’s reasons for raising capital.
Looking at the previous example of Amigo, diluting the shares was perceived as an admission of lack of reserves to pay the complainants. The share price dropped, and investors quickly fled before the level hit rock bottom.
Pre-Covid-19 and the complaints about its business practices, the stock price of Amigo Holdings hit a peak of 297.50 per share in December 2018. The stock price dropped significantly as the Ombudsman addressed customer complaints and the judgment was handed down.
After the announcement of the possible option of dilution, the stock fell by 60.1% to trade at 2.35p (28 January 2022), falling even further from the previous week’s closing price of 5.90p (21 January 2022).
Note that diluting shares can also be a springboard that catapults a company back to prominence in the long-term. In this scenario, share dilution means that the company does not go insolvent and can improve their business practices to be profitable in the future.
What is diluted EPS?
Diluted EPS is a metric used to analyse a company’s earnings figures if all convertible stock options are exercised. It’s calculated by taking the net amount of profit made in a period and dividing it by the number of shares that the company may be obligated to issue at a later stage.
What is the difference between share dilution and a stock split?
The difference between share dilution and a stock split is the number of shares that the investor is left with after each process. With dilution, the shareholder’s percentage of ownership in the company is reduced, to free-up more shares to raise capital.
When splitting stock, a company listed on the stock exchange divides the shares, and existing investors see their equity increase according to the determined split ratio. For example, if the split ratio is 2:1, the number of shares will double, and the stock price will be halved.
How to trade in share dilution
With us, you can get exposure to share dilution by opening a trading account. Trading is different from investing, please see the differences in the table below.
|Trading share dilution||Investing in share dilution|
|Take a position using CFD trading||Share dealing accounts (not possible with us)|
|Leverage your exposure – you’ll only pay a deposit to get exposure to the full position size||Pay the full value of the shares bought upfront|
|Leverage means both profit and loss will be magnified to value of the full trade – so you could gain or lose more money than you’d expect1||You might get back less than what you put in because as much as the value of shares can rise, it can also fall as well|
|Offset losses with CFDs2||In some territories like the UK, it may be tax free2|
|Take shorter-term positions||The focus is on longer-term growth|
To get started, we’ve collated a few steps that will help you ready to trade or invest with us:
What is share dilution summed-up
- Share dilution involves reducing the percentage of ownership in a company through the issuance of additional stocks
- Companies dilute their stocks for a number of reasons, such as to raise funds, add new shareholders to the holdings and earn more dividends in the future
- The process of diluting stocks affects companies and shareholders alike, with the purpose of reducing the percentage typically leading to a positive or negative outcome
- Diluting EPS is a metric used to analyse a company’s earnings figures if all convertible securities are exercised
- With us, you can get exposure to share dilution of a company by trading in the stock
1 Traders stand to lose more than their deposit margin and their loss will exceed their initial deposit when they use leverage. Therefore, it’s important to take steps to manage your risk
2 Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.
This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.
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