Stock dilution is an insidious danger to investors -- and can reduce the portfolio performance of those who aren't paying close attention.
Stock dilution happens when a company issues additional shares, which decreases, or dilutes, the value of existing shares. For example, imagine In-Your-Face Telemarketing Inc. (ticker: RINGG), which has 100 million shares outstanding, trading at about $50 each. Its current market value is $5 billion (100 million times $50 equals $5 billion).
In a simplified example, let's say that, to raise money, the company issues an additional 10 million shares. The company is still valued at about $5 billion, but now that's divided between 110 million shares -- so each share is worth roughly $45 ($5 billion divided by 110 million is $45). The shares have been diluted in value.
If the money raised is used to generate additional sales and earnings, long-term economic dilution might not occur. The money might end up generating enough to more than make up for the short-term dilution. In such a case the increase in share count would be worth it. But if shares are issued to finance value-destroying projects or overly generous stock-option awards, then value-destroying dilution is certain.
Companies are required to report earnings per share (EPS) in two formats: basic and diluted. Focus on diluted numbers, as they take into account stock options, warrants, preferred stock, and convertible debt securities, which can be converted into common stock, diluting the value of existing shares. Pay attention to the number of shares listed and see if they increase over time, and how quickly.
Some companies (among hundreds, if not thousands) that have or have had dilution concerns include eBay
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