During tough times, you depend on company management to keep your share prices from falling. Lately, however, managers have taken actions that hurt current shareholders. And unfortunately, there's not much you can do about it.
The credit crunch has led many companies to offer new shares to investors to raise capital, often at bargain prices. According to The Wall Street Journal, U.S. companies have issued more than $44 billion in equity so far this year. Although managers insist their actions are necessary to ensure the survival of their companies, current shareholders end up suffering twice: Their share of the company gets watered down, and their potential for profits, if the company recovers, becomes smaller.
Stock dilution and you
Secondary offerings of equity have become widespread. Last August, Bank of America
The core of the problem comes from stock dilution. By issuing shares for less than the current market price, the intrinsic value per share of the company falls. For instance, if a company with 1 million shares outstanding is fairly priced at $10 per share, and it issues another 1 million shares for $8, then the fair value of the stock falls to $9 -- theoretically costing current shareholders 10% of their investment.
Although banks and other financial institutions hit hard by the subprime crisis have had high-profile secondary offerings lately, the problem isn't limited to the financial sector. Chesapeake Energy
Similarly, last December, North American Palladium raised $86 million in an equity unit offering that valued shares at just $4. By late February, improving prospects for palladium had pushed the share price above $9. The company probably could have gotten a much better deal simply by waiting a few months.
When issuing shares makes sense
Of course, selling new shares to raise capital isn't always a bad move for shareholders. Sometimes, companies take advantage of temporarily high stock prices. For instance, last October, Wynn Resorts
When Berkshire Hathaway
Still, many companies are less lucky with their timing. Citigroup
When corporate executives face challenging situations, they're supposed to put the interests of shareholders first. Issuing new shares at fire-sale prices, however, forces existing shareholders to bear the cost of the mistakes those executives have made. If you see your managers acting against your best interest, it's definitely worth considering voting with your feet and getting out before you see any further damage to share prices.
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Fool contributor Dan Caplinger thinks shareholders sometimes get bad breaks. He and the Motley Fool both own shares of Berkshire Hathaway, which is also a Stock Advisor recommendation. Bank of America is an Income Investor selection, while Washington Mutual is a former Income Investor pick. Go ahead and print two copies of the Fool's disclosure policy; it won't be worth half as much.