What Is Dilution?

Dilution happens when the ownership stake percentage decreases due to more shares being issued by a company. During an initial public offering (IPO), corporations authorize shares to investors. But when the company decides to offer more shares of stocks after the IPO, called secondary offerings, it dilutes shareholders' equity position because more people own the same ownership pie of the business. A decreased ownership stake percentage also makes each outstanding stock less valuable, hence depressing the stock price. ?

What are the effects of dilution?

? Reducing earnings per share (EPS)

One of the ways that diluted ownership also depresses the stock price is by reducing the earnings per share (EPS). EPS is calculated as business earnings or net income divided by the company's total outstanding shares during a period. Therefore, when earnings stay the same, but the number of shares outstanding increases, EPS consequently reduces.?

Additionally, among the popular metrics, investors use to evaluate a company's share price, the price-to-earnings ratio (P/E) is the most prevalent. A high P/E ratio might tell investors the stock is overvalued, and a low ratio might indicate an undervalued stock. The P/E ratio is computed as stock price divided by EPS, so when EPS decreases in case of dilution, the P/E ratio subsequently increases, prompting investors to think the share price might be too expensive.?

? Acquiring more capital funding

Even though dilution is viewed unfavorably by equity holders – as it lowers their equity ownerships and stock's value – dilution provides a source of capital funding to companies. For businesses to receive more finances, equity financing, such as the issuance of common stocks or private stocks for privately held companies, represents one of the most effective methods to secure more funding capital. Businesses will have more financial backing to invest in fixed assets and spur new developments, improving growth and profitability. In the long-term, an increase in the company's fundamental strengths will make it more valuable and offset the depressed stock price resulting from the dilution.?

? Examples of share dilution

Suppose a business issues 100 shares for 50 investors. Each stockholder now has two shares of the company; that is, individually they own a 2% ownership stake. However, if the company decides to offer 100 more shares to additional 50 investors, then now although each shareholder still owns two shares, they only hold 1% of the company as an individual.?

A real-life example of share dilution would be Apple CEO Tim Cook receiving five million shares of apple stocks in 2021. The compensation package, which was worth $750 million at the time, was awarded to Tim Cook under a 2011 agreement, which stipulated Tim Cook's stock compensation based on Apple's stock performance compared to other corporations in the S&P 500. By introducing five million new shares, the company effectively diluted other investors' ownership stake, though only slightly.?

Another example is that AMD, a multinational semiconductor company, offered to buy Xilinx, also a semiconductor business, in an all-stock transaction. AMD agreed to acquire Xilinx with a $49 billion price tag, completed in February 2022. Instead of raising additional money to execute the deal, AMD purchased Xilinx by giving AMD's stock to Xilinx's stockholders. Because of this, AMD had to issue new shares to enable the acquisition, diluting the company's existing shares.?

Dilution protection?

To prevent the prospect of diluting the ownership of a company, investors sometimes demand dilution protection, especially when investing in a start-up. Dilution protection, or anti-dilution provision, is a contractual provision that restricts a corporation's ability to reduce an investor's stake in the business. The protection is automatically activated when there is a potential diminished percentage claim on assets, such as in the event of additional funding rounds or equity issuance.?

The provision is normally included in issues of stock options, convertible preferred stocks, and other convertible securities. Stock options and convertible securities are financial instruments that can be converted into common stocks at a predetermined condition and price. The anti-dilution provision mandates a downward adjustment to the conversion price if the company subsequently issues lower share prices to new investors.?

For example, suppose an investor was offered a conversion price of $10 for his preferred shares, including a dilution protection provision. If the new conversion price for the same type of stock is only $5 for new investors, then his original conversion price would adjust down to $5. By and large, this downward price adjustment allows existing shareholders to claim more shares than they otherwise would and maintain their current ownership percentage of the company.?

Share repurchase?

Another form of reducing dilution is share buyback. This is when a company repurchases its own shares – to prop up the financial metrics or return earnings to investors. A firm can repurchase its shares by buying from the market or giving shareholders an option to tender their shares to the company at a fixed price – the repurchased stock will be canceled or held as treasury shares. As a result, share buybacks reduce the number of outstanding stocks in the market, increasing the equity ownership percentage for existing investors.?

One of the most distinguished examples of share buybacks in the marketplace is Apple. According to a report from CNBC, the Cupertino tech behemoth spent north of $467 billion to repurchase its shares since 2022. Compared to all of Apple's peers in the S&P 500, Apple has been reported to be the biggest repurchaser of its own stock. Additionally, the company also shelled out $85.5 billion to buy back its stocks during the fiscal year of 2021. This amount is on top of the $14.5 billion Apple returned to its investors in the form of dividend payments during the same period.?