What Penny Stock Investors Should Know About Dilution - dummies

What Penny Stock Investors Should Know About Dilution

By Peter Leeds

Penny stock investors will often hear the term dilution and assume the worst. Dilution is often viewed as a negative thing for an investment, but like most things in the stock market, it is a little more complex.

Penny stock dilution a good thing

If the company needs more money after its initial public offering, it can sell even more shares to generate the funds it needs. Those new shares could represent a portion of the company that wasn’t released in the original IPO. Any newly issued shares are sold to investors, and the company uses the money for working capital, or to pay debts, or make an acquisition.

Issuing new shares can decrease the proportionate value of each existing and new share, a result that investors call dilution. If a company doubles the total number of shares, the amount of money each share represents drops in half.

Every company needs to balance the ability to raise funds with the concerns caused by dilution.

The most obvious reason for issuing more shares is to raise funds, but companies issue new shares for other reasons:

  • Raising money: Whether an IPO or a subsequent offering, this is an efficient way for any publicly traded company to generate funds.

  • Giving up control: When the founder (or organization) owns too much of a company, she can easily lower that percentage of ownership by selling a portion to new shareholders by way of stock sale.

  • Expanding the shareholder base: The more shareholders a company has, the better. In fact, many of the major stock exchanges require that companies listing with them have a minimum number of unique shareholders. By issuing new shares into the market, the shareholder base expands as new owners purchase shares.

  • Paying executives and key employees: Companies regularly pay their key employees, or lure top talent, via shares or stock options. Penny stock companies are particularly fond of this maneuver because they may not have much cash to compensate executives but are able to offer shares that have potential to increase in value.

  • Cashing in options and convertible debentures: Sometimes new shares are created by using complex financial instruments. For example, a convertible debenture is like a loan in which the creditor could be paid back the amount owed or could convert that value into new shares of the company instead. Options also become shares of the company if and when they are exercised, or cashed in.

Issuing new shares can help a publicly traded company by giving it the greatest flexibility to take advantage of opportunities as it implements its business plan. The benefits can be great, as long as the company is cautious of the potential for causing shareholder dilution.

How dilution affects penny stock investors

Dilution can have a detrimental impact on penny stocks. Any time a company issues new shares, the share of ownership of each stock is reduced. Your job as an investor is to ascertain whether a company’s dilutive financing is beneficial or detrimental to current shareholders. You want to avoid companies that don’t produce gains for their stockholders.

For a company with 10 million shares outstanding, each share represents ownership of 1/10,000,000th of that company. If it doubles the number of shares available, each one should be worth half as much.

Dilution can also hold share prices down even when the company’s value grows. Picture a company that trades at one dollar per share, while the number of outstanding shares doubles. If the shares are still at one dollar, but there are twice as many of them, that means the market capitalization has doubled.

In this example, shareholders own stock in a company that has grown in size but may not see any increase in the stock price because there are so many more shares available.

Less-experienced investors often don’t see the potentially detrimental effect that newly issued shares can cause. They may be proud of the 20 percent gain their stock has returned so far, not realizing that this occurred during a time when the company significantly diluted its holdings. Without that dilution, the investors’ returns may have been significantly higher, but this lost opportunity will never show up in any quantifiable way.

If you’re a shareholder in a company, you don’t want it to dilute your investment by issuing more shares. If you are not yet a shareholder in a company that you’re considering investing in, you don’t need to worry about dilution from the company, because it will simply make the shares you’re thinking about investing in both less expensive and more available.

Companies can also select the price at which they issue new shares or at which their options may be exercised. For example, they may announce a deal to sell shares at $2.25 to a specific buyer or that the IPO price will be $2.25.

Setting a share price can be beneficial for shareholders if the price is higher than the current share price. Issuing new stock at prices lower than current share prices can have a negative impact on the stock. In addition, current shareholders can also feel like they overpaid, or that management is giving away portions of the company at unfair levels.

The impact of dilution on shares isn’t instantaneous; instead, it has a gradual effect over time. However, because dilution implies lower shares prices, when a company announces that it will be issuing more shares, investors may react immediately by selling their shares.