Beware This Hidden Destroyer of Value

Share buybacks, done at the right price, can be a shareholder's best friend. Each share that a company takes off the market increases the value of your share. However, buybacks have an evil twin: share dilution. And it can eat into your potential returns.

An example
If you've purchased 100 shares of a company that has 200 shares outstanding, you have a 50% stake in the company and its earnings. However, if the company issues 200 more shares, shares outstanding jumps to 400 and now you only own 25% of the company. You've just lost half of your previous claim on the company's earnings.

Why shares are issued
Companies issue new shares for a variety of reasons, including rewarding employees, raising cash to repay debt or invest in new projects, or to acquire another company. These are all legitimate, but be sure the company acts judiciously. If a company begins tossing shares to employees like candy at a parade, it doesn't bode well for shareholder value. Or if a company finds itself selling off more and more shares to keep itself afloat, the viability of the business may be suspect.

Growing or steady
Let's look at two groups of companies, one whose stocks have seen significant dilution, and one whose stocks haven't:

The companies that increase shares outstanding usually are in a growth phase. For example, Dendreon (Nasdaq: DNDN  ) , the maker of the prostate drug Provenge, pumped shares from 82 million in early 2007 to 147 million today. The biotech firm had several secondary offerings to raise cash for funding research, trials, new manufacturing facilities, IT systems, and hiring employees. These investments seem to have paid off, as the company passed FDA trials and appears to be on its way to profitability.

Another company issuing plenty of shares: Star Scientific (Nasdaq: CIGX  ) . This alternative tobacco company's shares outstanding have ballooned from 79 million in early 2007 to the current 135 million. Star issues more shares so that it can simply survive as a company, spending the new cash to pay for expenses, and so far has little to show in return. The company hopes to turn the corner with its new tobacco-derived Anatabloc supplement, and the quarterly earnings coming March 13 will help paint the picture on how the supplement has been selling.

One final example of a company using shares to speed growth is Rentech (AMEX: RTK  ) . The synthetic fuel producer increased shares outstanding from 165 million at the end of 2007 to today's 225 million. Shares were sold to help fund the development of Rentech's renewable synthetic fuel center in Rialto, as well as help in the acquisition of SilvaGas in 2009. Rentech took note of its creeping share count, and recently announced the authorization of up to $25 million in share buybacks.

On the other hand, well established companies don't find it necessary to do secondary offerings so often. For example, Sun Life Financial's (NYSE: SLF  ) share count exemplifies a more stable company that isn't investing heavily in research or acquisitions. Over the past five years, shares have dipped and risen, but only between a low of 559 million to a high of 580 milllion. The financial services company recorded a $300 million loss this past year, but continued to give shareholders a hefty dividend (near a 7% yield).

And Intel's (NYSE: INTC  ) shareholder-friendly management takes its cash and not only gives back dividends to shareholders, but also takes shares off the market. Since 2007, shares have fallen from 5.85 billion to 5.09 billion. That means if Intel's earnings sat stagnant, earnings per share still would have increased by over 10% simply by reducing shares outstanding.

Watch that share count
Not all dilution is bad -- if Dendreon hadn't issued more shares, the company may not have had the cash required to bring its drug to market. However, a company must use its new shares or cash from selling shares wisely. Otherwise, it's an easy way for companies to hide underlying issues. And no matter what, share dilution is a great gauge of how companies treat shareholders.

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Fool contributor Dan Newman owns 100% of his portfolio. He also holds no shares of the companies mentioned above. Follow him @TMFHelloNewman. The Motley Fool owns shares of Dendreon and Intel. Motley Fool newsletter services have recommended buying shares of Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 08, 2012, at 12:35 PM, thefamilyman wrote:

    As you said, "Let's look at two groups of companies, one whose stocks have seen significant dilution, and one whose stocks haven't."

    Since December 30, 2011, the two stocks who haven't seen dilution have increased in value 13.5% (SLF) and 10.7% (INTC). While the stocks that saw "significant" dilution increased 28.3% (DNDN), 32.1% (RTK), and 78.9% (CIGX).

    Your point was?

  • Report this Comment On March 08, 2012, at 12:56 PM, TMFHelloNewman wrote:

    @thefamilyman

    Thanks for the comment. My point is that growth stocks can heavily dilute shares to fund their growth - sometimes this works out, sometimes it doesn't.

    While the 2 month timeframe represents a good short term view of recent performance, I'd be more concerned over the long term, like RTK losing over 40% since over 5 years.

  • Report this Comment On March 08, 2012, at 1:59 PM, bisom08 wrote:

    Mentioning any company in this article whose stock had climbed 66% over the past 52-Weeks is just plain silly.

    But the author (an expert on bagels not stocks) did just that.

    Issuing new shares is not always a "hidden-destroyer-of-value" because that ignores what the money is spent on.

    For Star Scientific, obviously the proceeds from the newly-issued shares have been spent productively.

    Just because the author fails to recognize this value does not mean it does not exist.

    Another case where MF serves as a shill for the Shorts.

  • Report this Comment On March 08, 2012, at 3:11 PM, TMFHelloNewman wrote:

    @bisom08

    Thanks for your comment. I explain that issuing shares can be a great strategy - especially for growth companies needing extra cash.

    However, with CIGX, I believe the jury remains out on whether or not the cash has been spent productively. I eagerly await the next quarterly report.

    I also have no financial interest in CIGX - I think it's great if it truly has a breakthrough product that alleviates pain.

  • Report this Comment On March 08, 2012, at 3:28 PM, NobHillSF wrote:

    Are you an utter rube? You are using a Dow 30 company that you have interest in that started in 1968 and a solid well regulated Canadian Insurance company founded in 1865 and only went public in 2000 to compare with Biotech/Pharma companies to illustrate a point about dilution?! Actuarial science versus Viagara?

    It is akin to comparing a Minivan to a Nascar Racer

    and pointing to the MPG rating and safety records.

    You miss the point of Capitalism and Stock Markets in the first place-access to capital! It might have been more palatable had you used Intel from 1968 to 1979 say or compare Junior Gold Miners in stages of development. By comparing Apples with Pomelos you render your readers

    a disservice and they will have known nothing of due dilligence, risk management and obfuscate your valid point about dilution.

    By your metric, your readers are better off just putting their money in the Fed and get a guaranteed rate of return, notwithstanding

    the negative real interest rates.

  • Report this Comment On March 08, 2012, at 10:54 PM, thefamilyman wrote:

    Thanks for the response Mr. Newman. If those commenting on your article seem a bit defensive, it's because we CIGX shareholders have come to expect that whenever the tide begins to go against the persistent short position, a seriously deficient article will be published by The Motley Fool. However, the fact is that your article is actually pretty tame compared to what we have come to expect.

    But perhaps you can explain why it is that whenever shorts are pushing back on the CIGX price, TMF comes to their aid with a poorly researched negative article?

    If not, perhaps you can explain to us how you came to write this article? Did someone at TMF suggest a topic, the timing, and/or the companies to include in the article?

    Thanks again for your response.

  • Report this Comment On March 09, 2012, at 10:56 AM, TMFHelloNewman wrote:

    @thefamilyman

    I think the amount of coverage on CIGX just represents the interesting story related to the stock - and timing of articles is random.

    Many writers at the Fool are independent contractors, like me. No one guides my views or topics. I chose to write about share dilution to teach those unfamiliar with the subject, and searched for representative companies. Neither the Fool, nor I have any financial interest - as stated in our disclosure statement. And if we did and lied, the SEC would have closed down the Fool long ago.

    Again, if Anatabloc works - I think that's fantastic! I'm just not swayed by the evidence so far. However, if CIGX starts racking in sales to justify its market cap, it may represent a very attractive investment. It could be that you are just way ahead of the curve than me.

    @NobHillSF

    I appreciate your comment. I think comparing the longstanding companies that are mature helped illustrate to the reader other cases of share management. And I also hope that I explained it's not a golden metric, but just something to keep in mind - as shown DNDN now has a drug on the market because of share dilution.

  • Report this Comment On March 19, 2012, at 7:45 PM, ChartMyStock wrote:
  • Report this Comment On April 17, 2012, at 9:42 PM, naughtyguy wrote:

    Look at the market cap...then look at sales and losses every quarter! I wouldn't waste my money buying this stock even if they did have a miracle cure. Long term side effects have yet to be studied?

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