How Dilution Works
Understanding dilution is essential to avoiding losses and picking stocks to sell short
This is the first in a series of educational articles that supplement our regular stock research reports.
Dilution is commonly misunderstood by beginning and even intermediate investors. Yet it can have a major impact on the price of a small- or micro-cap stock. The phenomenon occurs when a company issues additional shares, which increases its total shares outstanding.
For a large-cap company that has issued over a billion shares, issuing a million more shares barely registers in its stock price. But for a micro-cap company with only a million shares outstanding, adding another million shares to the count can slash the value of each existing share.
The potential for major price swings is even greater when a company has a thin public float. The public float is the amount of total shares outstanding that is not owned by company insiders, who are subject to trading restrictions. If a company has 1,000,000 total shares outstanding but a public float of only 600,000 shares, its stock price may be highly sensitive to increases in the supply of shares for sale.
A commonly used measurement of dilution is tangible book value per share. Tangible book value is the amount left over after subtracting a company’s liabilities from its tangible assets, which consist of all its assets except intangibles such as intellectual property and goodwill. Tangible book value per share is tangible book value divided by total shares outstanding, which indicates the amount of tangible book value allocated to each share.
Dilution at Acme, Inc.
Suppose Acme, Inc. has 1,000,000 total shares outstanding and a tangible book value of $100 million. That means its tangible book value per share is $100,000,000 ÷ 1,000,000 = $100. Therefore, if you buy one share of Acme for $5, you’re paying $5 for a claim to $100 of tangible book value.
But if Acme issues 1,000,000 additional shares and receives nothing in return, its tangible book value per share drops to $100,000,000 ÷ 2,000,000 = $50. Although you paid $5 for a claim to $100 of tangible book value, you’re left with a claim to only $50 of tangible book value.
In response to Acme’s issuance of 1,000,000 shares, the market price of its stock will likely drop to around $2.50 per share. That’s because, all other things being equal, owning a claim to $50 of tangible book value should cost half as much as owning a claim to $100 of tangible book value. In this case, shareholders who bought Acme’s stock before the company issued the additional shares are simply out of luck.
Of course, not all new issuances of shares are dilutive. If a company can command a high price for the shares it issues, the cash it receives from selling them may increase its tangible book value enough to offset the increase in total shares outstanding.
Suppose that instead of receiving nothing for 1,000,000 newly issued shares, Acme receives $100 per share from an investment bank that underwrites an offering for the company. Although Acme’s total shares outstanding increase to 2,000,000, the cash raised in the offering increases the company’s tangible book value to $200,000,000. Therefore, after the offering, Acme’s tangible book value per share remains $200,000,000 ÷ 2,000,000 = $100.
In practice, cash raised in an offering of newly issued shares rarely cancels out dilution. Instead, the effects of dilution are often mitigated by investors’ expectations. Suppose that instead of raising $100,000,000 in its offering, Acme raises $5,000,000. Although the amount is not enough to offset the increase in total shares outstanding, Acme’s management says the company will use the $5,000,000 to develop a new product over the next three years.
Investors expect Acme’s new product will result in future cash flows of $100,000,000 for Acme. Based on 2,000,000 total shares outstanding, that’s $50 of future cash flows per share, which may be enough to justify Acme’s current stock price of $5 per share or even increase the stock price.
Dilution while cash poor
However, suppose that after raising $5,000,000, Acme has a cash balance of only $5,500,000. The company uses about $1,000,000 per year simply to pay rent, payroll, and other recurring expenses. Despite management’s grand vision, Acme won’t have enough cash to develop a new product without raising more money, which means issuing more dilutive shares. Once investors figure that out, Acme’s stock price may begin to slide.
For companies in early stages of development, raising sufficient cash to fund operations while building a business is often the greatest challenge. In capital-intensive industries like biotech, young companies often require multiple infusions of cash over several years before they earn a dollar of revenue. The stock prices of such companies are based largely on conjecture.
Because of the high risk such companies pose to investors, they often must raise capital on unfavorable terms. In our next article, we’ll explore some of the common types of financing that favor institutional investors and lenders but are potentially harmful to individual investors.
This article appeared originally on The Activist.