Companies may need to raise capital and instead of borrowing, they can issue a share purchase plan or convertible securities. The benefit of these methods is that they do not take on more debt. However, the downside is that this can cause the stock to dilute. In this article we explain what a stock dilution is and the consequences when this occurs.
Why do companies dilute their stock?
Companies may issue share purchase plans to raise capital to fund a new expansion. They use equity financing as opposed to debt refinancing to raise funds as they do not want to take up any more debt. Debt obligations eventually need to be repaid but equity financing does not.
However, when a company issues more shares in the market then it dilutes the ownership for the existing shareholders. This can also mean the voting rights for existing shareholders decreases as it can affecting voting power.
Companies can also dilute their shares though convertible securities. Convertible securities pay regular interest payments and can be converted into shares. When the convertible securities holder wants to convert these instruments into common stock then this will dilute stock as there are more shares on issue.
Effects of stock dilution
Share dilution can cause share prices to decrease as there is more shares on issue, therefore increasing the supply of stock. Issuing more stock into the market also decreases the earnings per share (EPS) for the company. If the earnings of the company are unchanged but the shares on issue increases, then this will cause the EPS to decrease as you are dividing the earnings to a higher denominator (i.e., more shares on issues).
Do share splits dilute shares?
No, share splits do not dilute shares for existing holders as the amount of shares on issue increases but the share price is adjusted in proportion in the market. The market capitalisation value of the shares remains the same as per before the stock split. For example Tesla (NASDAQ:TSLA) offered a 5 to 1 in their latest stock split. So that means for every 1 share an investor owns, they now receive 5 shares. The dollar price of Tesla shares were getting quite high at $2,230 so the stock split was implemented. This was to make the stock price more accessible to more investors as it lowered the price to $446 after the split.
Lauren Hua is a private client adviser at Fairmont Equities.
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