Equity dilution
Equity dilution occurs when a company issues new shares to investors and when holders of stock options exercise their right to purchase stock. With more shares in the hands of more people, each existing holder of common stock owns a smaller or diluted percentage of the company.
Further, their share of the company’s profits is also diluted. This happens because the total number of shares goes up but the company’s earnings after tax stay the same, so earnings per common share go down. This often lowers the share price as well.
To mitigate these downsides, company leaders must ensure that money raised from the issuance of new shares is used to grow the company’s revenues and after-tax profits, raising the price per share above the pre-issue price.
More about equity dilution
In the example below, ABC Co. started with 100,000 shares owned by 100 unique shareholders—meaning each shareholder owned 1% of the company. To raise more capital, the business issued 10,000 new shares to 10 new shareholders, so that 110 shareholders now own 0.9% of the company each. As a result, each shareholder also has slightly less voting power.
Here’s the calculation:
Before dilution:
- # of common shares = 100,000
- # of shareholders = 100
- # of shares/shareholder = 1,000
- % ownership = (1,000 ÷ 100,000) x 100 = 1%
After dilution:
- # of common shares = 110,000
- # of shareholders = 110
- # of shares/shareholder = 1,000
- % ownership = (1,000 ÷ 110,000) x 100 = .9%
If ABC Co.’s available earnings after tax for common shares are $17,000, the equity dilution would have the following impact on each shareholder’s earnings:
Before dilution:
- EPS = ($17,000 ÷ 100,000) = 17 cents per share
After dilution:
- EPS = ($17,000 ÷ 110,000) = 15.5 cents per share