What is stock dilution?

A company is split into shares. When it creates more of them, every existing share becomes a smaller slice, even though nobody sold anything. That is dilution of ownership. It usually comes with dilution of earnings, because the same profit is divided among more shares, and sometimes with dilution of value, when new shares are sold for less than they are worth.

Dilution is not always bad. Money raised at a fair price and invested well can make each share worth more over time. The trouble comes when a company sells shares year after year to cover losses, or hands out large amounts of stock to employees, and the share count climbs faster than the business grows.

Shares outstanding
The number of a company’s shares held by investors, including insiders, at a given date. It changes when the company issues or buys back shares.
Fully diluted share count
Shares outstanding plus the shares that could be created from options, restricted stock units, warrants and convertible securities. Diluted EPS uses a version of it.

How do companies issue new shares? Secondary offerings and ATM programs

A secondary offering, also called a follow-on offering, is a sale of new shares after the company is already public, often through banks and often at a discount to the market price to attract buyers. An at-the-market (ATM) program is quieter: the company sells new shares into the market at the prevailing price through a sales agent, a little at a time, over months. Both usually rest on a shelf registration, which lets a company register shares in advance and sell them later.

In the drawing below, hypothetical XYZ has 100 million shares at $10.00, a value of $1,000 million, and sells 20 million new shares at $9.00, raising $180 million. Afterwards there are 120 million shares. If the company is worth its old value plus the cash, that is $1,180 million, or about $9.83 a share: selling below the market price cost existing holders about 1.7% of value per share. Your 1 million shares fall from 1.00% to 0.83% of the company either way.

Secondary offering (follow-on offering)
A sale of shares after a company’s IPO. When the company sells new shares it dilutes existing holders; when existing holders sell their own shares, the share count does not change.
At-the-market (ATM) offering
A program in which a company sells new shares into the existing market at prevailing prices through a sales agent, gradually, rather than in one block at a fixed price.
Shelf registration
A registration that lets a company file to sell securities in advance and sell them later, in one or more offerings, when it chooses.

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Three cards for hypothetical XYZ. Before the offering: shares 100 million, price $10.00, value $1,000 million. New shares sold: +20 million at $9.00, cash raised +$180 million. After, highlighted: shares 120 million, value $1,180 million, value per share $9.83 in red. A line reads your 1 million shares: 1.00% → 0.83% of the company, and a note reads if XYZ is worth its old value plus the cash, selling below the market price costs 1.7% of value per share.

Stock pay, convertibles and warrants: where else do new shares come from?

Not all dilution arrives in one announcement. Stock-based compensation pays employees in restricted stock units and options, which turn into new shares as they vest or are exercised, every year. Convertible notes are loans that can turn into shares at a set conversion price. Warrants give their holder the right to buy new shares from the company at a set price until they expire, and small companies often attach them to their offerings.

In the drawing below, hypothetical XYZ starts the year with 100 million shares. Stock pay adds 4 million, convertible notes 6 million, warrants 5 million and ATM sales 10 million. It ends the year with 125 million, +25%, the same total as the example at the top of the page, built from four sources.

Stock-based compensation
Pay in the form of shares, restricted stock units or options. No cash leaves the company, but the new shares dilute existing holders, and the cost appears as an expense.
Convertible note
A loan that the lender can turn into shares at a set conversion price, or by a formula. Conversion replaces debt with new shares.
Warrant
A right, issued by the company, to buy new shares from it at a set price until an expiry date. Exercised warrants add new shares.

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A waterfall of hypothetical XYZ’s share count in millions, on an axis starting at 90: start of year 100 in gray, then orange hatched steps up of +4 stock pay, +6 convertible notes, +5 warrants and +10 ATM sales, and end of year 125 in gray. The title reads +25 million in a year, +25.0%.

How much does dilution cost you? Ownership and EPS, step by step

Work it out from the share count. Using XYZ from the top of the page:

  1. Your ownership before: 1 million ÷ 100 million = 1.00%.
  2. New share count: 100 million + 25 million = 125 million.
  3. Your ownership after: 1 million ÷ 125 million = 0.80%, a fall of 20% in your share of the company.
  4. EPS before: $50 million ÷ 100 million = $0.50. EPS after, with the same profit: $50 million ÷ 125 million = $0.40, also −20%.
  5. To keep EPS at $0.50 on 125 million shares, net income has to reach $62.5 million, 25% more. Whatever the new money buys has to earn that much just to stand still.

Why does dilution hit small caps and penny stocks hardest?

Many small companies, especially those that lose money, cannot borrow easily, so selling shares is how they pay their bills. A company that burns cash may run an ATM program, raise money with warrants attached and issue convertible notes, all in the same year. Some convertibles convert at a discount to the market price, so the lower the price falls, the more shares they create, which can push the price lower still.

Share counts in penny stocks can double in a year, and a falling price can then lead to a reverse split, as that lesson explains. A low share price does not make a stock cheap, because what you own is a percentage of the company; see market cap. Before buying a small company, check how much cash it has, how fast it spends it and whether it already has a shelf registration or an ATM program in place.

Do buybacks offset dilution?

A stock buyback does the opposite of an issue: the company buys its own shares and the count falls. Many large companies buy back shares mainly to absorb the shares they hand to employees, so a buyback in the headline does not mean the count is falling. In the drawing below, a hypothetical company issues 4 to 6 million shares a year for stock pay and buys back 2 to 4 million. After five years of buybacks, its share count has risen from 100 million to 108 million, +8%.

Judge the net result, not the gross program. Compare the diluted share count over three to five years, and remember that stock pay is a real cost even though no cash leaves at the time; check free cash flow with and without it.

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On one side, five pairs of bars for years Y1 to Y5: orange hatched shares issued of +4, +4, +5, +5, +6 above a line, and red shares bought back of −2, −3, −3, −4, −4 below it. On the other, a card titled shares at year end, millions, with a rising red line through 100, 102, 103, 105, 106 and 108, marked +8.0%. A note reads buybacks every year, and still 8.0% more shares: watch the net count.

Where do you find the share count in a company’s reports?

US companies report share counts in several places, all free on the SEC’s EDGAR database:

  • The cover page of each 10-Q and 10-K: the number of shares outstanding of each class of common stock, as of the latest practicable date.
  • The income statement: weighted average basic and diluted shares for the period, the numbers behind basic and diluted EPS; see how to read an income statement.
  • The notes: stock-based compensation, outstanding options and units, convertible debt and warrants, with their conversion and exercise prices.
  • Offering documents: prospectus supplements and current reports announcing an offering, an ATM program or a shelf registration.
  • The trend: compare the share count with the same quarter a year earlier. A rise of a few percent a year adds up; a rise of 20% or more in a year deserves a close look at why.