At Motley Fool Hidden Gems, the Fool's premier small-cap stock newsletter, we spend a lot of time paying attention to picky little details that can trip up our subscribers on their road to financial independence. One pothole on that road is "stock dilution," a little-understood phenomenon that can siphon a company's profits away long before they trickle down to the individual shareholder. Gone unchecked, stock dilution poses a danger to the kinds of 24% returns our recommendations returned in 2004 (against a market return of 6%), and that's something we just won't stand for.

For the benefit of our current -- and hopefully a few of you future members as well -- the following is a short tutorial on the subject of stock dilution: why we don't like it, when we don't like it, and, perhaps perversely, when it can actually work to your benefit.

Stock dilution: What it is
Simply put, stock dilution is the issuance of new stock by a company, for any purpose. Some purposes are bad for outside shareholders (that's you and me). Some are neutral. Believe it or not, some are actually good. We're going to look at all three scenarios here, keeping things simple and laying it out for you straight.

Let's start with a make-believe company that we'll use as our guinea pig, and see how its actions can affect the ownership stakes of its shareholders. The company is a high-tech start-up that aims to one-up stun gun manufacturer Taser (NASDAQ:TASR). It's got a new weapon to sell that, while it can be "set to stun," can also be set to "disintegrate," transforming its victims into nothing more than a hollow afterglow. The company is called Phaser (Ticker: RAYGUN). In 2004, Phaser had 100,000 shares of common stock outstanding, a market cap of $1 million -- and $100 of net profits.

Now, we need one more guinea pig. Guinea pig No. 2 will be Joe Fool. He's an individual investor, and on Dec. 31, 2004, he bought 10,000 shares of Phaser stock. When the company reported its earnings, Joe was elated to learn that, by virtue of his ownership stake, he vicariously earned $10 worth of Phaser's profits. Little did he know what 2005 held in store for him.

Bad stock dilution (Go to your room!)
In 2005, Phaser decides to engage in the worst of the three main ways that companies dilute their shareholders: It issues 100,000 stock options to its CEO. For the time being, Phaser has a "basic share count" of 100,000 shares actually outstanding. But because its CEO will eventually exercise his stock options (i.e., tell the company to issue 100,000 shares to him, then sell them on the open market), Phaser now has a hypothetical, or "diluted" share count, of 200,000 shares.

That's bad news for Joe. Once the company issues those extra shares, while Joe will still own his 10,000 shares, his ownership stake will be diluted. What does that mean? Well, when Phaser's share count stood at 100,000, and it earned $100, Joe was entitled to 10% (10,000/100,000) worth of those profits: $10.

But when Phaser issues those 100,000 extra shares, Joe's shares will not equal 10%, but just 5% (10,000/200,000) of all shares outstanding. If Phaser earns $100 again in 2005, Joe's take from that haul is just $5. Poor Joe. (The CEO, on the other hand, gets 100,000/200,000 worth of the profits, or $50 -- lucky CEO!)

Thus, the primary reason Fools dislike stock dilution is that it often represents a transfer of wealth from outside shareholders (again, that's you and me) to insiders.

Ambiguous stock dilution (Wait in your room while I decide whether I'm angry.)
Stock dilution isn't always bad. But before we look at when it can be good, let's consider the iffy situation of a company that acquires another and pays for its purchase in stock. Say Phaser wants to expand its business, but it hasn't gotten its gun to work just yet. That poses a problem. As the solution, Phaser decides to buy out a rival, defense contractor General Dynamics (NYSE:GD). Since Phaser hasn't sold anything, and doesn't have any actual, er, cash, it wants to issue its own stock to General D shareholders in exchange for their shares.

Now, General D has a market cap of roughly $20 billion. With Phaser shares trading for $10 a stub, our intrepid Trekkie will have to issue 2 billion new shares to acquire its heart's desire -- diluting Joe and Phaser's other shareholders by 200,000 times. In what universe could that much dilution possibly be a good deal for Phaser shareholders?

The answer requires another question: Is Phaser overpaying for its purchase? If Phaser pays a price equal to General D's intrinsic value as a business, then the dilution created by the purchase does not really hurt Joe. Yes, Joe's slice of the merged Phaser/General D pie looks much smaller than his slice of Phaser alone. But the new pie is much bigger. Picture this: Joe's receiving a much thinner and longer slice of Phaser/General D pie, in return for his original wide-but-stubby slice of Phaser.

A smaller piece of a bigger pie? Yummy!
And there's another possibility to consider. Alone, Phaser may not be objectively "worth" the $1 million market cap that the market accords it. If Phaser's stock is overvalued, then paying for an acquisition in inflated-value stock may be a smarter move than paying in cash. During the go-go '90s, most every acquisition you saw being made by companies such as Cisco (NASDAQ:CSCO) or Microsoft (NASDAQ:MSFT) was paid for in richly valued stock. And should we see cash-rich companies such as Google (NASDAQ:GOOG) or Apple (NASDAQ:AAPL) make acquisitions in the coming months, I'd wager good money that they, too, will nonetheless choose to pay in stock (interpret that as you will).

Take my shares. please!
Which brings us to the third major form of stock dilution: secondary offerings. When Phaser gives 100,000 shares to its CEO for a nominal "exercise" price, that's bad for outside shareholders. But what if, before Phaser decides to go that route, the Internet message board rumor mill gets going and anoints Phaser as the next Travelzoo (NASDAQ:TZOO) moon-rocket stock? As Phaser's stock price doubles, triples, and then jumps 10 times more, company management reconsiders, decides to not issue options, and instead sells the 100,000 shares on the open market (at $600 a pop).

If the company's intrinsic value hasn't changed, if only its stock price has increased, then this is great news for Joe. After the secondary offering is completed, he again owns 10,000 shares out of 200,000, or 5% -- down from his original 10%. However, Phaser itself is now worth more -- not just from the rumor-bubble pricing of its stock, but intrinsically, too. Because the company has traded 100,000 shares for $60 million in cash. That cash now sits in the company's bank account, and Joe owns 5% of it: $3 million.

So, to sum up, whenever a company issues shares of itself at a price higher than their intrinsic value -- whether it does so to buy another company or to sell the shares and raise cash on the market -- an outside shareholder benefits, despite his percentage of ownership being diluted.

And there you have it: the three primary sources of stock dilution, and what they mean to you as an outside shareholder. Tackling all three at once, this has been a necessarily brief and somewhat condensed discussion of the phenomenon. We invite you to peruse our stable of 31 select companies that don't abuse their owners by signing up for a free trial of Motley Fool Hidden Gems. Learn how to protect your investments -- from the very companies you're investing in.

Fool contributor Rich Smith has no position in any companies mentioned in this article. The Motley Fool is investors writing for investors and has a disclosure policy.