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.
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
Another company issuing plenty of shares: Star Scientific
One final example of a company using shares to speed growth is Rentech
On the other hand, well established companies don't find it necessary to do secondary offerings so often. For example, Sun Life Financial's
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.