Stock Dilution: Don’t Get Diluted Out of Your Dividends
Income Investors Should Beware of Dilution
Earlier on, we looked at the interesting relationship between buybacks and dividends. Today, I want to talk to you about the opposite of buybacks: dilution.
Instead of repurchasing their shares, companies can also issue new shares and sell them to investors. This would cause the total number of shares outstanding to increase. Therefore, each existing investor would own a smaller percentage of the company. This is called dilution.
When you purchase a company’s stock, you don’t want your ownership to decrease. So why would a company deliberately issue new shares, causing dilution?
The answer is money. Companies can raise capital through two ways: debt and equity. Debt financing means borrowing money, which usually comes with specified interest payments. Equity financing, on the other hand, means raising money through the sale of shares that represent ownership of the company.
So when a company needs money and doesn’t want to increase its debt, it may choose to issue new shares to get some cash.
Unsurprisingly, dilution has the opposite effect on a company’s earnings per share to buybacks. An interesting example would be a company issuing new shares to finance its growth project, which can lead to higher profits. But because the total number of shares outstanding has gone up, the company’s earnings per share would increase by a smaller amount. In fact, it is possible for a company to report higher overall net income but lower earnings per share.
When you see something like that, you’ll know that growth was likely financed by new share issuances. Most companies also report the number of shares outstanding at the end of each quarter, so investors should check those numbers to see if their ownership is being diluted.
Furthermore, stock dilution can also lead to a higher dividend obligation for the company. No, I don’t mean stock dilution can translate to higher dividends. Instead, it often works in the opposite direction.
For instance, if the company has one million shares outstanding and has an annual dividend rate of $1.00 per share, it will spend $1.0 million on dividends every year. If the company issues another 200,000 shares, it will have a total of 1.2 million shares outstanding. Therefore, at the same annual dividend rate of $1.00 per share, the company would need $1.2 million to meet its dividend obligation after stock dilution.
Why does that matter? Well, because as income investors, you want your dividends to grow over time. The company might increase its total profit, but if there are substantially more shares outstanding than before, the increase in overall net income may not translate to an increase in per-share dividends.
Other than through the issue of new shares, stock dilution can also happen when insiders exercise their stock options, or when companies convert their convertible bonds, preferred shares, or warrants into common stock.
I do not hold the opinion that all share dilution is bad. Sometimes, when there’s an attractive growth project, the return from that project may outweigh the dilution effect. In that case, raising money through issuing new shares may actually benefit existing investors.
The bottom line is that investors should check their portfolio companies’ total number of shares outstanding at the end of each reporting period. If a company consistently dilutes its shares without bringing in more revenue or profit, you might want to reconsider your position in the company.