Dilution of a company’s shares is a common scenario in the equity market. However, there is multiple effects on the valuation of the company in terms of market value and EPS (earning per share) calculation after dilution. In this post, we are going to discuss how dilution affects the company’s valuation.
This is going to be a technical yet interesting post and we would advise our readers to read this carefully. Feel free to reach out to us or post comments in case of any doubts or clarifications.
1. What is dilution?
Simply define dilution is the term used to describe the reduction in ownership or voting rights in a company.
Let’s understand this through the following example.
Assume a Company A’s equity is divided into 100 shares and we own 10 shares in the company, i.e we own 10% equity in the company. Now, let us assume that the company decided to fund its expansion plans by issuing new shares in the stock market (follow-on offerings). So, on the day of issue, the company issued 100 new shares in the market and a foreign firm with interests in the Indian market acquired all of the new shares issued.
Now, the company’s new equity is broken up into 200 shares out of which the foreign investor owns 100 shares (50% of equity) while we own 10 shares (5% of equity).
In the example, the follow-on offering is said to be dilutive for the company’s shareholders since their effective ownership has decreased in the firm.
2. What causes dilution?
Dilution can happen due to various some of the reasons are given below (may not be an exhaustive list)
- Follow-on offerings in capital markets
- Conversion of options and warrants by the holders
- Conversion of convertible bonds into equity
- Offerings of new shares to partners during acquisition or Joint-Ventures
3. How to identify companies where dilution is likely?
In most cases dilution happens when the company has desperate needs for infusing capital into its operations. Since modern financial ecosystem provides multiples routes and opportunities to achieve this aim, the most common strategies used by companies are to raise capital through debt offerings or through the issuance of new shares in the secondary public markets.
In case the company raises money through debt, this route need not always result in dilution of equity holdings for the investors. Dilution through debt happens only in case the company pledges to give its equity as collateral for a certain amount of debt.
4. How to calculate the shares outstanding after dilution for calculating market cap?
The shares outstanding after dilution would simply be as per the following equation,
Total dil. shares outstanding = common shares +newly issued shares
where, the newly issued shares could primarily come from (but not limited to) conversion of convertible preferred shares, conversion of convertible debt and also from shares issuable from stock options
This is shown by the following expression,
Newly issued shares
= shares from conversion of conv. preferred shares + convertible debt + issue of stock options
The calculation of the new shares from convertible preferred shares and convertible debt are pretty straightforward since most of the time these shares and debt are issued at a fixed conversion rate.
For example, Assume a Company ABC has issued 1000 preferred shares and 50,000 convertible bonds amounting ₹50 Lakh in debt. Also, the company on the date of issue stated that each of the 10 shares of preferred shares could be converted for 1 common share and 5,000 of the bonds could be converted for 100 common shares.
The newly issued shares post-dilution would be the sum of 100 (from preferred shares) and 1,000 (from convertible bonds) which is equal to 1,100 new shares.
(The shares issued from stock options is slightly complicated and is usually calculated using the treasury stock method. We shall review this method in another post.)
5. How dilution affects the company’s valuation?
Dilution affects the company’s valuation of terms of its different calculations. Here’s how dilution impacts the company’s market value and eps calculation-
— Market Value
Due to the rise in the total number of shares outstanding after the dilution, Market Value may change significantly after dilution, depending on the extent of the dilutive effect of the newly issued shares.
The formula for calculating Market Value remains the same, except that we will now use.
Total Diluted Shares Outstanding instead of Total Common Shares Outstanding.
Market Value = Price per share Total Diluted Shares Outstanding
— Earnings per share
The impact on earnings per share due to dilution is may become quite profound depending on the extent of dilution and is very important since EPS is very commonly used by investors in the final calculation of the intrinsic value of a stock.
Since companies normally get a tax benefit for interest paid on debt, after dilution this benefit is no longer applicable and we may see our net income being boosted by the after-tax amount of debt.
Another change that happens is due to dilution of the convertible preferred shares, in case the preferred shareholders were paid the dividend out of the net income of the company earlier, they need be paid anymore after dilution since they have the same status and rank as the common equity holders in the company. The change in the formula due to the dilution is illustrated by the following expressions,
The basic EPS of a company is given by the following formula,
The diluted EPS of a company is using from the below formula,
6. Bottom line
In this post. we understood the impact of dilution on the valuation with the help of equity dilution example. Today, we learned that dilution can have a significant impact on the Market Value and EPS calculations of a company and may distort the true value if it is not incorporated during the analysis of a company.
Since dilution mostly comes at the expense of the common investor, we advise that our readers scrutinize the annual report to find whether dilution is good or bad for them. A careful look at the financial statements is required to make the necessary changes during dilution analysis. Afterall, a decrease in the existing shareholder’s ownership in a company also means a decreased profits.
That’s all for this post. I hope this is helpful to the readers. Happy Investing.
Levin is a former investment banker and a hedge fund analyst. He is an NIT Warangal graduate with around 5 years experience in the share market.