There has been a resurgence of news surrounding dilution and its impact on the credit crunch. Dilution means that the company is issuing new shares of itself to sell, without adding new value for the company. If there are 100 shares outstanding at a price of $20 per share and the company issues another 100 shares, the real value of the stock is about $10 per share. Corporations try to make up for this disparity by investing their newly obtained money in profitable mergers or acquisitions to add value to the company.
Banks are diluting quickly
However, today’s story is a bit different. Share dilution is becoming common business for banks and lenders that have suffered from large write-downs. To offset the losses, banks are issuing more shares at the cost to shareholder equity. For example, CIT group plans to sell $1Billion in new shares that will likely bring down the share price but boost the amount of money on hand. This is all done to make up for loan losses, but can and will hurt the overall value to the investor. This money won’t be going towards a new investment worth $1 Billion, but instead to cover its losses.
Three ways of dilution
Corporations have three different ways to dilute their shares or bring in new capital to the company. One of which is a warrant, which asks for further investment from shareholders. Another is the increase in common stock and most frequently, the increase in the amount of preferred stock.
Very seldom do corporations choose to issue warrants for stock. These usually call for an input of money from each investor for an amount proportional to the amount of stock held. This is usually done in corporations that are not publicly traded and work with a small group of shareholders. Warrants are typically enacted to protect the amount that each shareholder controls, but at the cost of further investment. Warrants usually turn investors off much more than a typical stock dilution as it requires the further input of capital.
New issues of common stock are more used than warrants, but not a favorite for corporations which usually issue preferred stock. A common stock dilution means that new stock is created out of thin air to help the depressed company or to finance a buyout. In some cases, this can be a positive thing for investors.
For example, during the internet boom, many high valued companies traded their stock for smaller rivals. Instead of paying cash, corporations could use their high values to take on competitors. If the stock price dipped, that cost was absorbed by the investors who owned the company being purchased rather than at the cost of the buyer. Most corporation finance buyouts with stock because it requires no new loans or the use of cash, which helps keep the corporation stable. Buying out a company with a PE ratio of 30 with the stock of a company with a PE of 50 is a very good investment, as you’re getting more earnings for less money.
Preferred stock is very similar to corporate bonds in that they carry no voting interest but a very high dividend. These shares can often be converted to common stock, which is unfavorable to investors. The problem with preferred stock is that the added cost of high dividend payments is passed onto common stock holders. When preferred stock is exchanged for common stock, the share prices are diluted and shareholder equity is lost to interest charges paid to preferred stock holders. For the most part, preferred stock is liked by preferred holders and hated by the owners of common stock.
Dilution is more evil than good
Whatever the method, share dilution for cash (second IPO if you will) usually depresses stock prices. Banks have consistently diluted their shares to spread out losses among many shares of stock and bring in new capital. Investors are unimpressed by new offerings and see it as a last ditch effort to raise capital. In this market, it is best to avoid rapidly diluting stocks in order to retain shareholder equity. Dilution is not usually a good sign for the financials of a company unless it intends on purchasing a rival or making further investments.