What Is Share Dilution?

What is share dilution?

Share dilution refers to the practice of companies increasing the existing share count, which dilutes the value of shares already issued. Share dilution can happen for a number of reasons. Among the most common is share-based compensation (SBC), also called stock-based compensation, which is typical in the tech industry.

With SBC, companies pay employees in company stock, using it as an incentive that gains value with the company's success. SBC is often tied to bonuses as well. The advantage of SBC is that it helps save a company cash and incentivizes employees. The disadvantage is that it dilutes the stock's value for existing shareholders.

Secondary offerings are also a common way for share dilution to take place. In this case, a company sells new shares to raise money, and those shares are added to the share count.

Why share dilution matters

Share dilution affects the value of your holdings. On a fundamental level, your holdings in a company have value as a percentage of the total number of shares available. When a company dilutes its shares, its earnings per share decreases relative to what it would have been. In that sense, share dilution can offset earnings growth and weaken an otherwise strong growth story.

Share dilution can be especially insidious with companies losing money because investors don't tend to focus on per-share results. In fact, with a company losing money, per-share results will actually improve with share dilution as the company's losses are spread across more shares or a larger group of investors.

Still, any company aims to turn profitable over time, so share dilution should ideally be avoided, or at least controlled, even if the company is losing money. Eventually, the costs of share dilution will affect the stock.

How share dilution affects investors

Although you should know how share dilution can sap value from your portfolio, you should also be aware of the opposite effect: share reduction. Companies can reduce their shares outstanding through share buybacks, a form of returning capital to shareholders that will make individual holdings worth more by raising per-share earnings. Some companies have a long track record of repurchasing shares, which helps them grow earnings per share over time.

Share dilution isn't always a bad thing. Sometimes, a well-timed secondary offering makes sense and can drive long-term value for a company by raising cash to expand or take advantage of a new opportunity.

Similarly, share-based compensation isn't necessarily bad either, but investors should be aware of how much dilution it's causing and how fast shares outstanding is growing. As long as it's reasonable, SBC is generally justified.

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An example of share dilution

One company notorious for share dilution is Snapchat parent Snap (SNAP -1.21%). Snap has used share-based compensation aggressively over the years but has also struggled to grow and turn a profit.

For example, since its 2017 initial public offering (IPO), Snap's shares outstanding has increased by about 60%. While SBC isn't the primary reason for the stock's challenges, its ongoing share dilution is a sign of poor management and the company's failure to create shareholder value.

Share dilution is complicated, and it's not always a negative for investors. If shares in a stock you own are being diluted, you'll want to understand why. It's also a good idea to assess whether it's hurting the value of the stock or is part of a long-term strategy to grow the business.