Dilution is the decrease in existing shareholders’ ownership percentage of a company that occurs when the company issues additional shares.
Understanding share dilution
A publicly traded company has a specific number of shares outstanding. When the board of directors decides to issue new shares to the public or to private investors, the total number of shares in existence increases. Because the total pool of shares is larger, each existing share represents a smaller fraction of the company. This reduces the proportional voting power of current investors and lowers the earnings per share, as the company’s profits are divided among a larger number of shares.
Companies issue new shares for several reasons. A primary reason is to raise capital to fund new projects or to pay down existing debt. Firms also create new shares to fulfill employee stock option plans or to acquire other businesses. While the issuance of new stock reduces the relative ownership stake of existing shareholders, the incoming capital is intended to increase the overall value of the company over time.
Investors distinguish between ownership dilution and value dilution. Ownership dilution happens in all cases where new shares are issued. Value dilution occurs only when the new shares are sold at a price lower than the current market value, which negatively impacts the share price. Elephants researching long-term investments monitor a company’s history of share issuance to calculate how their ownership stake and earnings per share might change in the future.
Example
Savannah Waterworks is a utility company with 1,000 shares outstanding. An elephant named Barnaby holds 100 shares, giving him a 10% ownership stake in the business. The company decides to build a new reservoir to secure water access during dry seasons. To pay for the construction equipment, Savannah Waterworks issues 1,000 new shares to new investors.
After the issuance, the company has 2,000 shares outstanding. Barnaby still owns his original 100 shares, but his ownership stake is now 5%. His voting power at the annual shareholder meeting is reduced by half. If the new reservoir generates enough revenue to double the value of the company, the monetary value of Barnaby’s 5% stake will remain stable or increase. If the project fails to generate revenue, Barnaby experiences ownership dilution alongside a decline in the financial value of his shares.