Stock dilution occurs when the total number of a company's outstanding shares increases. Stock issuance can cause several types of dilution. If a company issues shares at less than the current stock price, stock value is diluted. If a company doesn't increase earnings after a new issuance, the earnings per share is diluted. Unless a company issues additional stock to existing stockholders, shareholder ownership is also diluted.
Causes of Stock Dilution
A variety of events can trigger stock dilution. If a business needs to raise capital, it may decide to issue additional shares of stock to outside investors in exchange for cash. Stock dilution can also occur if employees or investors have convertible bonds or stock option plans. Investors with convertible bonds can trade their bonds for equity, which increases the amount of stock outstanding. Employees who were awarded stock options may choose to exercise them when the stock vests, which also increases the pool of outstanding stock.
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Stock Ownership Dilution
Unless the company offers more stock to the current stockholders, ownership is always diluted when additional shares are issued. For example, say that a company currently has four owners who all own 100 shares of stock, and the company wants to issue another 100 shares. Currently, each owner has 25 percent ownership of the company. Unless the business offers existing owners more shares of stock, their new ownership rate after the stock issuance will be 100 over 500, or 20 percent.
Stock Value Dilution
If the company issues stock at less than the current stock price, the issuance causes stock value dilution. Say, for example, that stocks are currently trading at $5 per share, and 400 shares are outstanding. If the company issues additional shares for $5 per share, no value dilution takes place. However, if the company is only able to get $4 a share for 100 additional shares, the total market value of the company is $400 plus $2,000, or $2,400. Divided over 500 shares, each share is now worth $4.80 and its value was diluted by 20 cents per share.
Earnings Per Share Dilution
Even if stock value isn't diluted, earnings per share may be diluted. If a company issues additional stock but isn't able to convert that capital into additional income for the company, the earnings per share will fall based on the amount of additional stock issued. For example, say that a company has 400 shares outstanding, issues 100 new shares, and income stays stagnant at $6,000. Before the issuance, earnings per share was $6,000 divided by 400, or $15 per share. After the stock issuance, earnings per share is $6,000 divided by 500, or $12 per share.