Stock dilution or equity dilution is a reduction in the ownership percentage of existing shareholders’ as a result of the issuance of new shares. When that happens, it has a negative impact on existing shareholders due to an increase in the total shares outstanding by new equity which has a very dilutive effect on the ownership percentage of existing shareholders. The result, the no. of shares each existing shareholder owns become smaller or diluted, making it less valuable.
This stock dilution has an adverse effect on fundamental positions of the company such as voting control, earning per share, ownership percentage, and individual shares etc. Especially, the stock’s earning per share (EPS).
Why a Company’s Diluted EPS Always Lower than its Basic EPS?
Well, the basic EPS is calculated by dividing a company’s net income minus any preferred dividends by the weighted average number of total common shares outstanding. For example, let’s assume there is a company named XYZ which had a net income of $18 million during this fiscal year. The company paid out $3 million as dividend and has $5 million shares outstanding. So, the resulting basic EPS would be
($18 million – $3 million)/$5 million = $3 million.
On the other side, in order to calculate the diluted EPS, one needs to understand that if a company has any convertible security such as stock options, convertible debt, and warrants, then the denominator will be larger than the denominator of basic EPS. So, a company’s diluted EPS can be calculated by dividing the company’s net income minus preferred dividends by any securities that can be converted into common shares.
Let’s take the above example of XYZ Company and assume it has stock options and warrants that can convert to 10 million common shares. Therefore, company ABC’s diluted EPS is
($18 million – $3 million)/$5 million + $10 million = 60 cents.
Final Thoughts: –
In a nutshell, we can say that dilutive stock is any security that generates the reduction where the company actions reduce the ownership percentage of current shareholders. Lower diluted EPS is the best example to understand the negative connotations of dilutive stock. It is the reason of decreases in the value of investor’s holdings.
In the stock market, the retail investors should be aware of signs that may introduce a potential share dilution.
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