Dilution of Share Value
Watch out for developments that cause a dilution effect on the value of your stock shares — that is, that cause each stock share to drop in value. Specifically, dilution means that your earnings per common stock share have declined. If this earnings per share figure declines, investor interest in the common stock also is likely to decline. The most basic level of measuring earnings per share involves common stock.
Sometimes the dilution effect may be the result of a good business decision, so even though your earnings per share decreases in the short term, the long-term profit performance of the business (and, therefore, your value of the common stock shares) may benefit. But you need to watch for these developments closely. The following situations cause a dilution effect:
Issuing additional shares: A business issues additional stock shares at the going market value but doesn’t really need the additional capital — the business is in no better profit-making position than it was before issuing the new stock shares. For example, a business may issue new stock shares in order to let a newly hired chief executive officer buy them.
The immediate effect may be a dilution in the value per share. Total earnings are the same, but those earnings are spread over more common stock shares. Over the long term, however, the new CEO may turn the business around and lead it to higher levels of profit that increase the stock’s value.
Offering additional shares at a discount: A business issues new stock shares at a discount below its stock shares’ current value. For example, the business may issue a new batch of stock shares at a price lower than the current market value to employees who take advantage of an employee stock-purchase plan. Issuing stock shares — at any price — has a dilutive effect on the market value of the shares.
But in the grand scheme of things, the stock-purchase plan may motivate its employees to achieve higher productivity levels, which can lead to superior profit performance of the business. Finally, keep in mind that issuing shares at a discount means that you don’t raise as much capital for the business.
Now here’s one for you: The main purpose of issuing additional stock shares is to deliberately dilute the market value per share. For example, a publicly owned corporation doubles its number of shares by issuing a two-for-one stock split.
Each shareholder gets one new share for each share presently owned, without investing any additional money in the business. As you would expect, the market value of the stock drops in half — which is exactly the purpose of the stock split. The lower stock price may attract more investors. After all, 100 shares of a $20 stock cost less than 100 shares of a $40 stock.
Note that a stock split doesn’t change the total market value of the company. When the number of shares is doubled in a two-for-one stock split, the value of each share is cut in half. As a result, the total market value stays the same.