Companies often decide that they want to raise more capital on the financial markets. For publicly traded companies, issuing more stock through a secondary offering is an option to get cash for use within the business. The downside of secondary offerings is that they often send a stock's price lower. Let's take a closer look at why that typically happens.
What a secondary offering does
After a company goes public, its shares trade on the open market. Buyers and sellers determine the market price of the shares, and that helps to establish public perception of the value of the company.
If the company wants to raise more capital by offering stock, the current market price sets an upper bound on the amount it can expect to receive for each share. When the company approaches potential buyers for the secondary offering, it can't set a price above the current market price, because buyers would simply buy the shares on the open market rather than participating in the offering.
To entice buyers to participate in the secondary offering, companies typically offer to sell their shares at a discount to the current market value. Because buyers and sellers on the open market are aware of the secondary offering, the price they're willing to pay for the shares usually falls in line with the amount of the discount.
After the secondary offering, if the company has sold stock at a discount, the intrinsic value of the company falls on a per-share basis because of a phenomenon called dilution. For example, say a company had 1,000 shares of stock worth $100 per share. The value of the whole company before the offering is therefore 1,000 x $100 or $100,000. If the company does a secondary offering of 1,000 shares at $90 per share, then it would expect to raise $90,000 in the offering. The $90,000 in cash would boost the value of the company to $190,000, but there'd now be 2,000 shares outstanding. That works out to $95 per share, or a $5 reduction from the original price.
Secondary offerings don't always result in dilution, especially if a company is particularly popular. Yet even the fear of potential dilution is often enough to send share prices downward, at least temporarily. Shareholders need to be wary of secondary offerings to make sure they don't see their existing holdings lose too much value.
If you find this confusing, you're not alone! Consider consulting an experienced broker to help you untangle these issues.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!