Keeping in mind the theme of value investing, I’d like to dedicate the next two posts to the discussion of equity dilution, and how its impacts can be worked into a value-based portfolio. For our purposes, equity dilution is going to refer to situations in which the values of an investor’s equity holdings become less valuable on a proportionate basis. This can generally occur as a result of an increase in the total number of shares issued.
As a personal investor, this can have a number of implications on our portfolio, and our ability to realize returns over a number of different time horizons. By the end of this article, you’ll understand where it is you’ll see these impacts. In the next article I’ll then follow up to discuss how it is that these negative implications can be avoided.
The first cause of equity dilution that I’m going to discuss today is over-issuing stock. Particularly with smaller companies, it is difficult for management to say no to investors that are looking to give the company more financing for future operations. Perhaps a mutual fund has approached the company, and has expressed a willingness to purchase a large amount of shares, but only for bulk pricing.
In this situation, it is possible that the management might approve the issuance of additional shares, in order to accommodate the new holder. While this action creates a favorable situation for the company, in that it allows them a fantastic new source of capital for new projects, it dilutes the holdings of all other investors. Since the company had to issue new shares to accommodate the large purchase volume, the percentage of the company that each individual investor owns is reduced.
The second cause of equity dilution is a much more continuous process, and involves the company gradually diluting investors out over time. The issuance of equity-dividends provides a fantastic opportunity for smaller investors to gradually build up their holdings in a company over time. Additionally, it allows investors to easily re-invest their dividends into a company, while allowing the company to save cash-flows for re-investment into valuable projects.
However, they are simultaneously presenting dilution risks for any investors that choose to instead receive cash dividends. For every time that an investor opts for a cash dividend instead of an equity dividend, they are diluted out of value, in that their position is no longer worth as much in proportion to the company as a whole. While this may not result in any immediate consequences, it is important to consider how it is that this can impact an investor over the long term.
Eventually, the position will become inconsequential, and the re-investment value of the position will become contingent upon how it was the cash-flows from the dividends themselves were invested afterwards, as opposed to the performance of the company itself.
Now that we have those two broad concepts under control, I’ll jump into the details in the next posting about exactly how the associated dilution risks can be mitigated through some simple pre-cautionary steps.
