Dilution refers to a dilution (lowering) in earnings per share or book value per share caused by issuance of additional shares or options.
When companies issue stock options, your share of earnings is diluted. This is not a concern if the number of stock options is relatively small and represents fair compensation and incentive pay for executives. However, investors need to wary of management that rewards itself with obscene and obese amounts of stock options. JDS Uniphase is the worse case I know of. In 2000 the president was awarded a staggering (sickening to me) 9.6 million stock options.
I personally would tend to simply avoid investing in a company that does this. Warren Buffett reportedly believes that it is important that you trust management. I don’t trust those managers (the hired help really) who appear to be attempting to grab an unfair portion of the company away from its owners through excessive compensation (granted to them by compliant boards of directors who are supposed to be looking after the owner’s interests).
This is why my reports discuss management compensation.
Dilution also generally occurs every time a company issues shares. When your company issues new shares your earnings might be diluted but your book value will actually often be increased (anti-diluted). If a company with a high price earnings ratio issues shares that will usually increase the book value per share. For high tech companies with high share prices, it is a very smart move for the company to issue shares. This may dilute your earnings (or losses) but usually substantially increases your book value per share. This moves puts cash in the bank and can put a floor under the stock price since the shares will not usually decline below their cash value per share. In my opinion Nortel made a huge error by not issuing shares for cash when the price was high. Instead they issued hundreds of millions of shares for what (it seems) amounted to worthless junk. A few $billion in the bank would have protected the stock price.
In purchasing an IPO you are usually subject to dilution in book value. You may be paying $10.00 for a share that has a after IPO book value of $1.00 (90% dilution). In some respects this is irrelevant, if the company is worth $10.00 per share based on earnings, then the fact that the book value is $1.00 will never be a concern. But if earnings falter you have almost no book value to fall back on. I get nervous when an IPO dilution is too high. If you organize a successful company, I don’t expect to get shares for book value but I’m pretty nervous paying say more than double book value.
The IPO is how some company organizers get rich without ever actually making a cent. They invest say $1 million. Then they convince the world to buy say 25% of their company for say $10 million. Voila, the 75% that they paid $1 million for is suddenly worth $30 million. They quietly sell off an additional 25% of the company to investors for $10 million more . Now they have extracted $9 million in profit on their $1 million investment and they still own 50% of the company. The $9 million profit came from investors and not from earnings. Now, even if they never earn a dime and the stock price goes to zero, they still have $9 million in their pockets. Nice work if you can get it. In reality it’s not usually that easy and it’s not easy to convince investors to pay inflated prices. But in the dot com error this formula was repeated daily.
In the IPO case the company founders benefited from anti-dilution. They might sell a stock with a book value of $1.00 for a price of $10.00. The dilution suffered by investors is to the benfit of the company founders. After the IPO with ash in the bank the company shares will have increased in book value. For example start with $1 million shares with book value $1 dollar each. Sell $1 million shares for $10 million. Now the book value is $11 million / 2 million shares = $5.50 per share. IPO investors suffer $4.50 in dilution while the company founders gain $4.50 per share in anti-dilution. It’s all fair if the company can live up to its potential.
Shawn Allen, CMA, MBA, P.Eng.
InvestorsFriend Inc.
January 11, 2002