The words "shareholder dilution" might send shivers down investors' spines, but it's not always a bad thing.
In this clip from crossover week on Industry Focus: Healthcare, analysts Gaby Lapera and Kristine Harjes break down the basics of shareholder dilution and reveal how sometimes it can actually be beneficial for investors.
A full transcript follows the video.
This podcast was recorded on Nov. 16, 2016.
Kristine Harjes: I figure we'll start off with some basics. Gaby, do you want to kick it off and tell us about what dilution is, and why it matters?
Gaby Lapera: Yes, I would love to. Dilution, much like the chemistry term, means that you are becoming less concentrated. Shareholder dilution in particular means two really important things: one, that the economic power of the share that you hold is less, and two, your voting rights are less because the share makes up less of the company. Let's back up a little bit, because I realized I just jumped straight into the conclusions of dilution and didn't actually explain what it was. When companies decide to issue more stock, they don't magically have more assets, so the stock becomes less in price because there are more of them. It's a very simple equation.
Harjes: I think of it like a pie. You have the same size pie -- you can chop it up into however many pieces, but you still have the same pie at the end of the day. I think that's why there's such a negative perception of shareholder dilution, because if you are holding on to this piece of pie that you paid good money for, you don't want to see it suddenly get smaller. But there are good reasons why companies will dilute. Some of the really common ones are, for example, to pay for an acquisition. Sometimes it's to raise money. Maybe you need that to service your debt, or something like that. Another really common reason why shares become diluted is the conversion of stock options granted to employees or board members. A bunch of companies will give their executives, or their employees in general, the option to convert these securities into common shares. And when they actually do exercise that option, it dilutes the current shareholder base.
So, this can be a good thing or a bad thing. It's largely a bad thing. Most people are not pleased when they hear that they're being diluted. But it actually could be a good thing, which is kind of an interesting case. Say, for example, your company is overvalued, and you know it. Which, hopefully, you bought it when they were undervalued, and now you're sitting on an overvalued company. Regardless -- say a company is overvalued, and the company goes to pay for an acquisition using stock. That's smarter than doing that using cash, because the shares are worth more than the cash value. At that point, you could be very happy to see that, because this slice of pie that you have accumulated is suddenly a bigger pie. It's cut up more ways, but the pie is bigger, so that's a good thing. But in general, it's not the best. Many times, you can perceive it as a transfer of wealth from the retail investor to the insiders, when you have the exercise of stock options.
You also have the option of it being pretty neutral, which is kind of the same as the case when it's good, except that that would be if you're using it in an acquisition where you're paying a fair price, and the company that you own is also fairly valued. That's net-net -- your slice of the pie is smaller, but the pie is proportionately bigger, so it's pretty neutral.