You may have heard of an IPO, that’s when a company first issues shares to the general market. But did you know that a company can also issue shares after its IPO? This is called a secondary offering and it may be a good or a bad event.
Stock dilution is bad. The percentage of shares that you own in a company decreases. Your vote may not hold as much weight either. But, it can be beneficial to fund a growing company in need of cash. The bottom line is whether or not the cash created from a share issuance add value.
There are a lot of nuances when it comes to stock dilution. It’s not always bad, but once I’ve purchased a company I would rather not see my stock in the company reduced. On the exception that my share valuations rise in price.
Stock Dilution Can be Good or Bad
When it comes to growth stocks, stock dilution can be a driving force behind greater and greater revenues. These increased revenues can either be at the expense of profit or alongside it. Most growth companies are trying rapidly to reach economies of scale where they can really drive profit margins and benefit the shareholder.
On the other hand if a company does not have a product that people want and is not growing its revenue, it needs to re-evaluate its business plant before it issues stock at the expense of the shareholder. In these cases the stock price may be low enough to warrant share buybacks instead.
When Stock Dilution is Beneficial
2020 has been a historic year in terms of entire industries being wiped out. One of these was the cruise ship industry. There are 3 major stocks that are listed on the market that had their revenues evaporate and profits disappear.
- Carnival Cruise Lines (CCL)
- Norwegian Cruise Lines (NCLH)
- Royal Caribbean (RCL)
They essentially have an over 1 year waiting game where they need cash to stay afloat while they cannot operate. In order to do this they have raised their debt levels, but some have also used other methods.
Carnival Cruise Lines decided it would issue $1.5 billion in shares. This is diluting the shareholders on record and is making it much tougher for the stock price to reach its previous highs.
Now, this can be perceived as good or bad for a few reasons. Without it, Carnival could go bankrupt and wipe out its shareholders completely. So issuing more shares as long as there is a demand saves all shareholders. While it looks bad on the surface it is better than bankruptcy.
But, the shareholders need to understand that while their investment is safer, their upside potential is not as great as it could have been without share dilution. So the share price levels it was at previously are not the levels it will return to when operations begin and profits return.
When Stock Dilution is Always Bad
In the case above the share price is actually above its cash on hand and even book value for Norwegian. This means issuing shares is actually beneficial to the company, the reason is because the shares are being overvalued.
If for instance the company had more cash on hand than the company share price was selling for. As is the case with Benjamin Grahams net nets. Then selling shares would rapidly reduce the value of the stock price and this is always bad. In that instance issuing debt is likely a much better choice.
Growth Stocks and Incentives
There are a lot of instances where it may seem like your shares are being diluted but in fact they are not. So it is important to look at diluted weighted average shares outstanding. This is what you can look at in order to see whether or not new shares are being issues, or treasury shares are just being sold or given out as employee incentives.
Many times if a company believes its stock price is cheap it will buy its own shares. It can either cancel these shares reducing the diluted weighted average shares or it can retain them as treasury shares.
By retaining these shares it can give them out as stock incentives to its employees or it can sell them to the open market if the stock price is overvalued.
In this way the company can increase its own value, without even increasing its own operational profits.
Growth stocks will often continue to issue new shares as it grows. It can hold onto these shares and offer them to new employees to attract top level talent. If the stock price has been rising then they can be very attractive to new employees.
But, this often only works if the share price is rising as soon as the company takes a turn for the worse, it becomes extremely detrimental to the stock.
Share Buybacks the Opposite of Stock Dilution
When companies want to raise money they often do so by selling shares on the open market. But, they can also do the opposite. Companies can buy their own shares on the open market when they think they are cheap and have enough cash to acquire the stock.
This can create excitement and juice the returns of the stock. This is most famously happening in the late 2010s. Apple is flush with cash and has made a commitment to shareholders to return this excess cash in the form of not only dividends but share buybacks.
This can pose a bit of a problem though. If shares of Apple are overvalued than buying back its own shares will actually be detrimental in the long term. Its essentially creating its own micro bubble which will cause a crash when it stops buying back shares and demand for those shares decreases.
Buying Dollars for Cents
Although its very difficult to determine whether a company is overvalued or undervalued in terms of revenue growth or free cash flow. It becomes much simpler when you look at it in terms of balance sheet investing.
Balance sheet investing is a way of looking at the companies overall assets and its liabilities and coming up with a valuation for a stock. In some cases there are stocks trading on the market that have a stock price that is less than all its current assets combined.
The formula is as follows:
(Net Current Assets – Total Liabilities)/ Diluted Weighted Shares Outstanding
Note: We use diluted weighted shares outstanding as it takes into account all currently issued shares.
In these cases a company can buy its own shares below value and increase the overall value of the company. In 2020 while few of these companies can be found on the US stock market most of them can be found internationally and most commonly in Japan.