In finance, dilution occurs when a company issues new stock. This results in a decrease, or dilution of the existing stockholder’s ownership. It it sometimes referred to as stock dilution or equity dilution. Stock dilution can occur for a number of reasons such as the exercise of employee stock options and warrants or the conversion of other optionable securities such as convertible bonds. However, the biggest concern in trading and investing in merger arbitrage is the share dilution caused when an acquiring company issues new stock. This is done in order to pay for a target firm and is known as a stock deal or stock swap.
Following the dilution, the relative ownership percentage of existing shareholders in the company is reduced. As new shares are issued, the number of outstanding shares increases. Each existing share becomes less valuable. This change in value will depend on the capital raised in the share issue, and the markets perception of how this additional capital will be used by the firm.
To issue a number of new shares, the stock is commonly sold at a discount to the current market value. Generally market skepticism about the validity and necessity of the takeover in question also often causes the price of acquirer stock to fall in addition to shorting the stock for merger arbitrage trading. When combined, the factors can have a serious negative effect on the acquirer stock price. Understandably, share dilution is not often viewed favorably by existing shareholders.
Share Repurchase Programs
The opposite of dilution is a share repurchase program. Companies initiate share repurchase programs to undue the effects of dilution when there is surplus cash or to take advantage of low interest rates and reorganize the firm’s capital structure. Following the abandonment of the HP merger by Xerox, HP has stated it will continue with its buyback program. Suggesting a repurchase is a favorite tactic of activists.
Dilution Example
The issuance of new stock generally occurs for either of the three reasons given below
- Conversion of optionable securities –
- Employee Stock Option Program (ESOP)
- Convertible bond
- Warrants
- Secondary offerings raising additional capital – New capital to fund growth opportunities via capital investment or takeovers
- Offering new shares in direct exchange for acquisitions – A company may offer new shares in a share swap deal to the shareholders of a target firm
- Conversion of optionable securities –
If a business has 100 shareholders and each shareholder owns one share, they would own 1% of the firm. Let’s assume the company issues 100 new shares in a secondary offering and a single investor buys them all. The firm now has 200 total shares outstanding with the new investor owning 50%. Subsequently, each existing shareholder now owns just 0.5% of the company. This is one share out of a total of 200. Their ownership has been diluted.
To calculate the effect on earnings per share and the subsequent in the PE Ratio following the dilution we use the following formula
Diluted EPS = (Net Income − Preferred Dividends) / (Outstanding Stock + New Stock)
