Imagine you're hosting a baking class and preparing 60 cupcakes, thinking that around 30 people would sign up. You planned to give each participant 2 cupcakes to decorate and take home. Unexpectedly, 45 aspiring bakers show up on the day of the class. To ensure everyone could still enjoy the experience and take home some treats, you distributed one cupcake to each participant instead of 2. This way, everyone can learn and create their own delicious masterpiece.
The concept of share dilution works similarly. Continue reading to know what share dilution is, how it works, and its potential impact on shareholders.
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The term share dilution is also known as stock dilution or equity dilution. It happens when a listed company issues new shares, thereby reducing the ownership percentage of the existing shareholders. Share dilution may occur when company employees purchase stock options or noteholders decide to convert their convertible notes.
Once share dilution happens, a company's total number of shareholders increases. However, the value of each share, and subsequently the stakes of the existing shareholders, decrease.
Let’s now understand the concept of share dilution with the help of an example. Suppose a company, ABC, decided to sell 50% of its equity in 100 shares. An investor, XYZ decides to purchase 50 shares of the ABC company. It means he now has (50/100) of the 50% stake, i.e., a 25% stake in the company.
After some time, the company decides to issue 100 new shares without diluting its equity pattern. As a result, the company's total outstanding shares increased to 200. Thus, the new shareholding percentage of the investor XYZ in the company became (50/200) of 50%, i.e., 12.5%.
When discussing share dilution, referring to the diluted earnings per share is crucial. This reflects the actual earning of a shareholder after considering the impact of share dilution. The formula to calculate the diluted earnings per share (EPS) is as follows:
Diluted EPS = Net Income of the Company – Preferred Dividends / WA + DS
Here, ‘WA’ is the weighted average of a company's outstanding shares, and ‘DS’ is the value of the conversion of dilutive shares.
As per the Securities and Exchange Board of India (SEBI) guidelines, all listed companies must mention the diluted earnings per share for investors in their annual financial statements.
As an investor, you could face the following consequences in the event of share dilution:
We have already explained above how your ownership percentage in a company can reduce if it announces share dilution. When the total number of outstanding shares increases, the value of each share goes down. Subsequently, your stake in the company also declines. The reduced ownership percentage can further lead to several other consequences.
Your voting power within a company depends on your ownership stake in it. The larger your ownership stake, the greater your veto power. However, in the case of a share dilution, your ownership percentage in a company decreases, diminishing your voting power on crucial business decisions.
When a company issues new shares, it attracts more investors. In turn, the total number of shareholders in a company will increase. If the company issues dividends, it will be split even further; hence, the existing shareholders' portion will automatically reduce.
As evident, your earnings per share will decrease if the number of shareholders in a company increases but the revenue remains stable.
A sharp decline in share price is noticed whenever a company announces share dilution. It’s because of two reasons – First, the value of each share gets reduced because of dilution. And second, share dilution is perceived negatively in the market, leading to a drop in the company’s share price.
Share dilution can hurt the financial portfolio of existing shareholders. However, acquiring a company’s shares at low rates can be an opportunity for new investors. But as an informed investor, all your investing decisions must be backed with careful analysis and thorough planning.
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