Stocks can play an important part in diversifying a portfolio. Share prices can fluctuate, depending on various market movements. But there’s something else that can affect what your stocks are worth: dilution. Stock dilution can influence the value of each stock you own and affect your portfolio as a whole.
Consider working with a financial advisor as you respond to a dilution of your holdings or seek ways to protect your investments from such a development.
What Is Stock Dilution?
Stock dilution happens when additional shares of a company’s stock become available to investors. There are a couple of different ways this can happen. But it most often occurs when a company issues more shares of stock. A less common way to dilute shares involves investors exercising stock options.
When more shares of stock are issued or options are exercised, your ownership share in the company shrinks. In other words, it dilutes your stake. A good analogy is to think of it in terms of slicing a cake or pie. When the pie is split four ways, you can claim a 25% ownership share. But if a pie is re-sliced into eight pieces, your ownership share is now cut in half to 12.5%.
You still own part of the pie, i.e. the company you’ve invested in. However, there’s more of it to go around for other investors. As a result, you now own less of it than you did before the dilution.
Why Companies Dilute Stock
There are several reasons why companies may opt to issue more shares. However. raising money is one of the most common motivators. When a company goes public for the first time, it does so through an initial public offering or IPO. That IPO allows the company to raise money so it can continue to scale and grow. At the very least, it can fund day to day operations.
Stock dilution can help raise money for the next stage of growth. It can also help a company just meet its overhead. Essentially, the company can just issue more shares to the market as a secondary offering to attract investors. Investors buy those new shares. That allows the company to raise money and dilute ownership shares of existing investors in the process.
For some companies, this option might make more sense than taking on debt or selling off assets to raise capital. Dilution can also happen when companies issue stock options to employees and those employees then exercise their options. Companies can also issue new shares to a select group of investors. That’s especially true if a company is acquiring or merging with another company.
However, dilution isn’t the same thing as a stock split. With a split, the number of shares increases while the price of each share decreases. But no new shares are issued. So going back to the pie analogy, instead of owning 1/4 of the pie you’d now own 2/8 instead.
What Stock Dilution Means for Investors
Stock dilution can be worrying for investors since it means that your shares are now worth less money. Keeping a dilution event in perspective can help you gauge the impact it may potentially have on the value of your holdings going forward.
For example, say that a company issues more shares to raise money to fund a large-scale growth project that eventually boosts revenue and profits. If that happens, the value of your shares could increase as more investors seek to capitalize on the company’s growth.
On the other hand, issuing more shares could spell trouble for investors. Especially if a company desperately needs capital. If a company issues more shares because it can’t raise the funds it needs to cover day-to-day operating expenses, it could be a sign of financial instability.
The circumstances of share dilution can influence how you react. For example, you may decide to do nothing in a situation where the company has a strong growth outlook or more shares are created through employees exercising stock options. Or you may see it as an opportunity to buy up more shares at a discount before they jump in price again.
On the other hand, if the company seems to be struggling you may decide to cut your losses and sell if it doesn’t look like the stock’s price will climb enough for you to recoup lost value. It’s important to keep in mind that dilution doesn’t have to be permanent, however. Companies can pursue stock buybacks, in which they buy back shares of stock to reduce the number being traded on the market. This can essentially reverse the effects of dilution since your ownership share in the company would increase.
How to Spot Potential for Dilution
There’s no precise way to predict if or when a company will offer additional shares to the market or employees will exercise options. But you can get a sense of how well a company is doing by studying its fundamentals and it’s short- and long-term outlook.
For example, some of the things you might consider include what’s on the company’s balance sheet as far as assets and liabilities go. You can also consider historical pricing trends, earnings and revenue growth. Meanwhile, consider stock pricing relative to the broader market. Past history isn’t always a perfect indicator of future performance but the more you know about how a company operates and its financials, the better.
The Bottom Line
Stock dilution isn’t necessarily ideal. However, it can have positive side effects if share prices increase.
Consider why dilution happens and what it means for your ownership stake. It can help you make better decisions when dealing with these types of disturbances within your portfolio.
Investment Tips
- Consider talking to a financial advisor about what to do next if shares of a company you own become diluted. If you don’t have one finding an advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Diversifying your portfolio and including exposure to different asset classes can help to offset stock dilution. Bonds can help balance out stocks. So can owning a mix of both U.S. and international stocks. Meanwhile, consider stocks from different sectors and from companies with varying market capitalization. Adding real estate, commodities, precious metals and other investment alternatives to your portfolio can also help. This way, when one investment underperforms or loses value you have others to help balance it out.
Photo credit: ©iStock.com/peterschreiber.media, ©iStock.com/holwichaikawee, ©iStock.com/Deagreez