New Penny Stock Shares: Good or Bad? - dummies

New Penny Stock Shares: Good or Bad?

By Peter Leeds

It can be difficult to determine the meaning behind trends in penny stocks. If your company is increasing shares, should you sell or is this the sign of an expanding company?

When new penny stock share issues are a good thing

Dilution isn’t always a bad thing. Sometimes it can actually be very beneficial for the company. In such circumstances, the shares can rise much higher, not in spite of dilution, but rather due to the benefits of issuing new shares.

Dilution can be effective when used properly or conducted for the right reasons:

  • Legal battles: Smaller companies often find themselves in costly legal battles with much bigger players. For example, many tech companies must go to court to enforce patents rights. To pay legal fees, companies may issue shares for general working capital purposes. When the company is on the right side of a legal battle, it can be beneficial for them and shareholders to dilute in order to litigate.

  • Accretive acquisitions: When a company plans to acquire another company, a factory, or a brand that will immediately increase the penny stock’s revenues (and possibly earnings), it makes sense to acquire them. While sometimes expensive, if the acquisition makes the corporation stronger, investors should look beyond the dilution to the greater gains.

  • Attracting key personnel: Having the right people leading the company and in other key roles is of monumental importance. Issuing new shares to attract and retain the right personnel may be an acceptable practice.

  • Bridging: Short-term, or bridge, financing can sometimes take a company to profitability, or the next level, or put them on a higher playing field. When dilution generates a bridge or temporary financing, it is often acceptable, especially when that bridge leads to something even better for the corporation.

The negative impact of dilution on the share price is generally limited when spread out in small chunks over longer time frames, as opposed to issuing huge amounts of new shares all at once. For example, one million new shares sold into the market at four times throughout a year will have less negative effect on the stock price than issuing all one million of those shares at once.

Almost all penny stocks will take dilutive actions. As an investor, you want to focus on the companies that do so in a responsible way — a way that helps the company and its share price in the long run.

Unfortunately, many penny stocks companies issue new shares in a less responsible way, which can negatively impact the shares’ abilities to make long-term gains.

When new penny stock share issues are a not-so-good thing

Many penny stocks find it easy to raise money on the stock market but, unfortunately, they don’t always use those funds wisely. When a company makes poor decisions with the money it can result in a slow (or possibly not-so-slow) decrease in the value of the stock and your investment.

Watch dilutive actions closely, especially for financings that don’t do much to benefit the corporation. You should be very cautious when you see shares issued in certain circumstances, such as to:

  • Keep the company afloat. Many penny stocks companies would be long bankrupt if not for a few financings. Some of them raise more money from diluting shareholders than they do from generating revenues. Each time they seem to be running low on cash, they simply go back to the markets for more. Investors eventually spot companies that use this tactic, and when investors disappear, often so does stock.

  • Overpay top executives when the company is languishing. Using dilutive practices to overcompensate top executives is even more troublesome when the individuals receiving the huge bonuses and salaries are the ones who voted for them in the first place. While not common, you will see key personnel from time to time who take disproportionate payments, even when the underlying shares are languishing.

  • Generate easy money. Many companies find it easier to generate the funds they need just by issuing shares rather than controlling costs and running their business well. It typically takes less work to raise ten million dollars on the stock market than to earn ten million dollars through operations of the company. When corporations are quick to take this easy road, they could be diluting shareholders into the ground.