When looking at the differences between the basic earnings per share (EPS) and diluted earnings per share metrics that we have discussed in previous articles, it can sometimes be confusing to figure out exactly how it is that we can use this sort of information to make a meaningful contribution to our investment research. As personal investors, why is it that we should be concerned about whether or not a company’s debt is exchanged out for equity, or if its employee stock options are executed at below market price, if all we care about is our dividend payments and our capital gains.
There are a few reasons why it is that a personal investor needs to keep dilution risk in mind, and therefore be aware of how it is that diluted/basic EPS metrics impact their portfolios. Firstly, the dilution risk of converted securities is a function of risks that are associated with the underlying capital structure of a company. This means that the conversion of securities into equity (and therefore dilution overall) represents a shift in the company’s debt-to-equity ratio to favour equity (especially when the conversion results from a debt security).
This could place the company in a situation where it cannot afford to pay out as many dividends as it would normally (because there are a greater volume to pay). Alternatively, it makes it more difficult for the company to issue further equity securities in the future, as the dilution will generally lower the price of the shares themselves (because each share is now worth less individually). It essentially restricts a company’s ability to fall back on the equity markets to finance investments.
Another major reason why it is that personal investors should pay attention to dilution risk is because it might be an indicator of risks that we weren’t previously aware of. For example, if a large number of insiders suddenly convert their options into equities at once, perhaps there is a major turnover coming up, or some sort of event arriving that we need to be looking out for so as to not get caught holding a bad position.
In the case of convertible debt, the conversion of the debt into the equity may be a result of actions taken on by aggressive or disgruntled lenders that are want voting shares so that they can begin taking actions to reclaim their obligations from the company. They would essentially be converting their debts into voting shares so that they can begin forcing the management team to start liquidating assets, and paying out distributions that will ensure that they receive their principle back.
Between the ability of dilution to corrupt a company’s capital structure, or the provide minority interests with a large amount of voting control over the company, it is important for personal investors to keep track of exactly how it is that companies are positioning themselves in terms of capital allowances, so that we can be sure about the integrity of our investment’s capital structure into the future. By simply keeping track of the differences between basic and diluted EPS, we can fundamentally achieve this goal.