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Finance and capital markets
Course: Finance and capital markets > Unit 6
Lesson 6: DilutionStock dilution
Why the value per share does not really get diluted when more shares are issued in a secondary offering. Created by Sal Khan.
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nice explanation, but still one question, who has the right to issue share and make the owenership of the company under risk(eg. if some have 51% and one other 49%, the 51% may loose the company if the issue more shares)?(14 votes)
Usually, shareholders have a preemptive right. That means that they have the opportunity to buy new shares before others can. They are permitted to buy enough so that their interest in the company won't change. Basically, it protects an existing stockholder from involuntary dilution of ownership interest. So, if I own 25 shares of a company that has 100 shares outstanding, I own 25% of the company. If the board of directors decide to issue 100 new shares of stock, I have the right to buy 25 more before the new stock is available to the public. That way, my ownership in the company stays at 25%. However, it is up to the shareholder to exercise this right.(51 votes)
Sal said that new shares are usually valued at slightly less than the previous market price, so doesn't that mean that shareholders are losing some money, albeit very slightly?(10 votes)
Yes, dilution does hurt the price of the stock most of the time. though there are some situations were it could increase the value. It would require that no one was selling the stock, company was worth more than the 'trading price' because it would be outdated, and that the new shares reached the market outside of those sitting on it. But that's pretty rare.(7 votes)
Can a publicly traded company issue new shares whenever they want and as many times as they want or is there a limit to how many times a company may issue new shares? Thanks.(5 votes)- A company's bylaws will usually say what the maximum allowable number of shares is. But bylaws are routinely amended as needed to allow companies to do what they think they need to do. THere are some regulatory requirements on how new shares are issued and sold to the public, but for the most part you can say that a public company can issue shares as the board of directors sees fit.(7 votes)
- What would stop a company from continually issuing more shares to keep raising capital? Is it just the notion of diluting ownership?(2 votes)
- Nothing would stop them, but what would be the point?
Let's say I have a bank account with $100 in it. I turn it into a company and I sell shares. I divide it into 10 shares. Each one must be worth $10, right?
Now I decide to raise capital. I sell 10 more shares. My stock was already selling for $10, so I price the new shares at $10. After the offering, the bank account has $200 but there are 20 shares out, so how much is each share now worth? Still $10. I haven't really accomplished anything except to make the bank account bigger.
Real companies are more complex than a bank account but the principle is the same. If the shares are worth $10, and you sell another one for $10, the shares are still worth $10.
In a real issuance situation, the challenge for the company and its bankers is to convince investors of the value of the shares and to find enough convinced investors to raise the amount of money that the company hopes to raise. You can easily imagine that you are not going to have much luck taking your $100 bank account and trying to raise $100 million at $10 per share, right? People are going to want to know what you are going to do with their money once you have it. You need a good story if you want people to hand over large sums.(5 votes)
- I'm confused. It seems to me that the original 4 shares have each lost $1 in value as a result of this transaction. The pricing of the shares doesn't change the underlying value of the asset - if someone was willing to pay $2 for a share in the secondary offering, doesn't that mean they would have been willing to pay $3 for one of the original shares, had it been offered? So that's a loss of value to the original shareholders.(3 votes)
No, as he shows at3:06, the assets of the company got larger. Whether people are willing to buy a lot more shares is going to depend on their confidence in management to do something useful with the money though. If the company is issuing new shares to build a factory as Sal mentions, great maybe. If it's issuing shares in order to buy something useless, the market might not pay $2 for new shares (or for the old shares.)(2 votes)
If 3 people have pieces of the business- 25%, 33% and 42%. Does that mean the guy that has 42% owns the company even if he is not the CEO, Manager and he's just a rich random guy?(1 vote)- Probably not. It depends on the bylaws of the particular company but normally you would need 50.1% of the voting rights to ensure control. Under the situation you described, the 42% guy needs one of the other two to go along with him to elect the board or to approve any measures that require shareholder approval.
You should also distinguish between "own" and "control". Even someone who has 50.1% only owns 50.1%. Any dividends paid out would have to be paid on a per share basis, to the other owners would get their fair share.
(There are some companies that have dual share structures that enable someone to control the company by having voting rights out of proportion to her ownership, but that is not the norm.)(3 votes)
- 1:38- I don't really understand the explanation of the pricing for the secondary offering. If the core company assets are worth $8 and now you have 6 shares why would anybody buy it for $2 (or maybe slightly less as he describes in the video). I would think the share price should now be $1.33. But I guess maybe the markets are expecting that the assets will be worth more because of the capital that is being raised by their own purchase? It sort of seems circular and like money is being 'printed' in some way. Maybe the investment bank somehow signals how much they're trying to raise so that the equity markets can figure out how much that would affect the assets and also share price, right?(2 votes)
What happens if you buy more than 50% of a company's stock? Would you be considered the owner?(1 vote)- In most cases, 51% will gain you control of the company.(2 votes)
- I still don't quite understand. For example, with the netflix stock that is going under a 7:1 split. If I buy 1 share for $700 before the split, then after the split i will own 7 shares for $100 each. Now why wouldn't it makes sense to buy the 1 share before the split? The stock has a better chance of rising to $110 a share at the lower price, giving me a profit of $70 since people can now afford to purchase more of it, then i do of the stock raising to $770 a share. correct?...please help(1 vote)
- Not correct. A 10% increase is a 10% increase. There is no reason why 100 to 110 is more likely than 700 to 770.(2 votes)
- You are awesome!! One question tho... Is there any reason you have decided to measure the effect of dilution by the change in asset value per share (assets -liabilites / total outstanding shares) as opposed to Earnings Per Share (revenue - dividiens paid / total outstanding shares)?(1 vote)
3:06Video transcript
Let's say we've
got a company here that has exactly four shares
just to simplify things. Obviously, very few companies
have only four shares, but this will simplify
the explanation. And let's say that
each of those shares right now they're
trading in the market, or I guess we could say
the last transaction that's occurred in trading
in the shares, they're trading at $2 a share. So the market is saying
that each of those shares are worth $2. There's four of these
shares in total. And we're going to assume
that this company has no liabilities. So the shareholders just
outright own the assets. So if there's four of
these shares times $2, the market is saying that
this company's assets are worth exactly $8
right over here. The market value of the
assets is the same thing as a market cap in this case
because we have no liabilities. Now what I want
to think about is what happens if the company
wants to raise some more money? Let's say that they want
to issue some more shares and sell them to raise
some money to buy a factory or whatever. So what they literally
do is the board approves for them to literally
create two more shares. So now they have a total
of six shares outstanding. And then the company goes,
they get an investment banker, and they do a secondary
offering in the public markets. And they sell these
incremental shares. And they're able to
sell them-- let's just say for simplicity--
at $2 per share. Normally when you increase
the supply a little bit, you won't get quite what the
previous market value was, but you get roughly $2
a share for simplicity. And by selling two shares that
it just created for $2 a share, the company is able
to raise another $4. So the whole reason why I'm
going through this exercise is to ask a question. Did dilution take place? And there's different
ways to think it. When you think
about dilution, it's like you could imagine
if you have a sweet syrup and if you add water to
it, it becomes less sweet. Each kind of a cube of that
water, each drop of that water has less sugar in it. You've diluted it. And so there seems to
be an analogy here. We now have more shares
for the same company. And it is true. If you are the
owner of this share over here before the
share offering up here, you owned 25% of the company. After the share
offering, you own 1/6. So after, you own 1/6
or approximately 16%. So it looks like the percentage
that you own of the company has been diluted. And that's true to some degree. But sometimes the dilution
takes on another meaning, that somehow because
more shares are being used for the ownership
of the same company, that maybe these
shares are worth less. And that's the one thing
I want to challenge. There is dilution in
the percentage you own, but there is not dilution in
what the shares are worth. Because before, if you had four
shares representing something that is worth $8, now
you have six shares representing
something that is $12. Because the company didn't
just issue these shares and get nothing
in return for it. It got $4 of cash. You can't debate the value
of $4. $4 are worth $4. So now the assets of the
company are worth $12. So you have $12 of assets,
no liabilities, six shares, $12 divided by six shares
is still $2 a share. So the value per
share has not been diluted, just the
percentage of the company that you happen to own.