Jul 24, 2014 Investment Education – Dilution
When a company raises money by selling new stock, its existing shares (the shares outstanding before the new stock offering) will be “diluted”. Dilution is a key concept in investing, and one that often confuses new investors. Stock dilution can be a big risk in certain companies, notably small biotechs and other rapidly growing companies that need to raise capital to finance future growth. Here is a brief example of dilution: XYZ Corp is expected to earn $1,000,000 dollars this year, and has 1,000,000 shares of common stock outstanding. So its earnings per share are expected to be $1.00. If XYZ now sells a new 200,000 shares of stock, it will then have 1,200,000 shares outstanding after the new stock is issued. With the increased number of shares outstanding, the expected earnings per share will fall to $.83, or 17% lower than the $1.00 per share expected before the new stock issuance. With lower expected earnings per share, XYZ’s stock price can also be expected to fall by around 17%, other things being equal. Of course, other things are rarely equal, so the stock might fall more or less, or even go up. A typical reason why the stock would not fall with the announcement of a dilutive stock offering is that the market had already anticipated the offering, i.e. expected it was coming. When this happens, the stock often declines in advance of when the new stock offering is announced, and then the stock price does not react much when the stock offering is announced.
Investors can often predict when a small biotech will need to raise money, and approximately how much money. The cash a company has available can be read on the most recent quarterly Balance Sheet. How much money a company is spending on its R&D, drug trials, and other expenses, called its “burn” rate, is usually available either from the company’s press releases, website, or elsewhere on the internet. Thus investors can see how long the company has before it runs out of money. Because companies typically like to raise money 6 – 9 months before they need it, investors can often correctly approximate the timing of a new stock offering. Companies doing a stock offering like to raise at least 12-18 months of needed cash, but that will vary depending on the current price of the stock and market conditions.
How much dilution a company’s stock will suffer depends on how many new shares are issued. How many share will be issued depends on the price of the stock and the amount of money the company wants to raise. This gets complicated because the more new shares a company sells, the more the old stock is diluted, further depressing the stock price. We discuss this in our book, “Why Stocks Go Up and Down” in chapters 5 and 6 in some detail, and with numerical examples to make sure this important concept is fully understood.
Discussions of dilution require investors to understand the difference between primary and secondary stock offerings, which in turn are often confused with initial public offerings (IPOs). Similarly, investors need to know how primary and secondary offerings tie into public and private offerings. In the next few posts, we will present some questions and answers regarding these topics. Most are from our old exams, and you can be sure that very few students got them all right the first time. Please note that the answers given here cannot be as complete as in our book. If you need a more in-depth explanation, we encourage you to get the book, or find some other source of information to help you understand this material thoroughly. These topics are fundamental to investment understanding.
At this point, someone always asks, “do I really need to know this? I could have bought Apple stock 10 years ago without knowing any of this, and I would be retired now.” My response is that if you are confident enough that you can pick the next Apple, and are willing to put enough of your money into that one stock so that it can really impact your financial picture, then maybe you don’t need to know all these fundamentals. But with that exception, we think you will become a better investor over time and over a diversified portfolio, as you enhance your knowledge of investment fundamentals.
For more information, please visit our website at whystocksgoupanddown.com
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