Watching for the Dilution of Stock Share Values
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. Sometimes the dilution effect may be the result of a good business decision, so even though your share of the business has decreased in the short term, the long-term profit performance of the business (and, therefore, your investment) may benefit.
The following situations may cause a dilution effect on stock share values:
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. 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.
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.
Selling stock shares at a discount, by itself, has a dilution 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.
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 split because the lower stock price is better for stock market trading (according to conventional wisdom).