In this article, we will explain what diluted shares are. We shall look at some formulas and examples associated with these types of shares. Furthermore, we shall look at sources as well as the pros and cons of share dilution.

For instance, if you have an ownership stake of twenty percent (20%) in a company that has one thousand (1,000) outstanding shares, it means that you own two hundred shares out of all the shares the company has issued. If some years later the company needs to raise more funds either for business expansions or acquiring tangible assets such as machinery, they may choose to offer more shares for sale.

Suppose the company offers an additional one thousand (1,000) shares, it means that although you still hold the same number of share whose price might still be the same or even higher than when you first bought it, your ownership stake in the company has been affected by half. You no longer have a twenty percent (20%) ownership stake, instead, your ownership stake has been reduced by ten percent (10%) meaning that you only have a ten percent (10%) ownership stake.

Generally, once a company dilutes its shares by making a new offering of shares, it affects the share price due to the influx of new shares in the market. Other factors that could affect the price of shares include:

• The market forces of demand and supply
• Publicity about the company or its board of directors
• The release of new innovative products or services
• The company’s financial standing

The offering of new shares for sale by a company that leads to the reduction of the ownership stake of previous shareholders is called share dilution or stock dilution. The dilution occurs due to the distribution of share ownership to a wider pool of investors.

Reasons why companies offer new shares

1. Purchase of nonphysical assets such as copyright, intellectual property, etc
2. Mergers or acquisitions
3. Opening subsidiaries
4. Purchase of physical assets such as land, property, machinery, furniture, etc
5. Research and development of new products or services
6. Repayment of debt
7. Expansion to new locations, regions, countries, or continents

Companies offer new shares for sale for several reasons. The major reason is for increasing the company’s revenue. Once that is achieved, the additional capital could be used for any of the reasons listed above or any other project which the company raised the capital for.

See also: Equity stocks

Share dilution sources

1. Follow-on offering
2. Vesting of restricted shares
3. Conversion of convertible preferred shares and convertible bonds
4. Exercising stock options

Follow-on offering

This is the most common source of share dilution. When a company first offers its shares for purchase by the public, it is known as an initial public offering (IPO). Subsequent offerings of new shares for purchase by new investors are known as follow-on offerings. When this occurs, it leads to the dilution of the previously issued shares.

Vesting of restricted shares

Companies grant restricted shares to their employees as a form of compensation. These shares are normally granted with conditions attached, once the conditions have been met, the shares are said to have been vested and the employees to whom the shares were granted now owns these share leading to an increase in the company’s outstanding shares and hence, share dilution.

Conversion of convertible preferred shares and convertible bonds

Convertible preferred shares and convertible bonds when issued by a company usually have a predetermined date on or after which their holders can choose to convert them to a preset number of common shares of the same company. When these shares and bonds get converted, they can also lead to stock dilution since the total number of holders of common shares has increased.

Exercising stock options

Stock options are another form of equity compensation to employees, it grants employees the ability to purchase a certain number of the company’s common shares at a stipulated period. If the employee exercises their right to purchase these shares, they will definitely add to the outstanding shares of the company thus there will be a share dilution.

Related: Stock options and preferred shares

Diluted shares formulas

1. Diluted shareholding
2. Diluted share price

The above listed are the two (2) diluted shares formula. One tells the shareholder the extent of the dilution while the other shows the extent to which the share price was affected.

Diluted shareholding formula

The diluted shareholding formula is especially useful for existing shareholders in companies that are undergoing or have undergone a share dilution. The formula informs the shareholder about the extent to which the share dilution has affected their ownership stake in the company. It is calculated by dividing the number of shares you own in a company by the sum of the already existing shares and the newly issued shares.

The diluted shareholding formula is expressed as Diluted shareholding of A = N_A ÷ N_E + N_N

Where

N_A = Number of shares owned by shareholder A

N_E = Total number of existing shares

N_N = Total number of new shares

But in order to effectively understand the extent of the shareholding dilution, you will need to know your current shareholding before the share dilution happened. This can be done by dividing the total number of shares you own by the total number of outstanding shares. It is expressed as Shareholding of A = N_A ÷ N_O

Where

N_A = Number of shares owned by shareholder A

N_O = Total number of existing shares

Diluted share price formula

The diluted share price formula informs the shareholder about the extent to which the company’s share price was affected due to the share dilution. It is expressed as Diluted share price = [(C_P x N_E + P_N X N_N) ÷ (N_E + N_N)]

Where

C_P = Current price of existing shares

N_E = Total number of existing shares

P_N = Issue price of new shares

N_N = Total number of new shares

Diluted shares calculations

Example one

Suppose Harry owns one thousand (1,000) shares of a car manufacturing company and the company’s total outstanding shares are four thousand (4,000). If the company decides to issue two thousand (2,000) new shares, we can determine to what extent Harry’s ownership stake in the company using the diluted shareholding formula. But before we do that, we will first calculate his shareholding before the share dilution using:

Shareholding of Harry = N_A ÷ N

N_A = Number of shares owned by Harry = 1,000

N_O = Total number of existing shares = total outstanding shares = 4,000

Shareholding of Harry = 1,000 ÷ 4,000

Shareholding of Harry = 0.25%

Now that we know Harry’s current shareholding, we can then proceed to calculate what his shareholding will be after the issuing of new shares using the diluted shareholding formula.

Diluted shareholding of Harry = N_A ÷ N_E + N_N

N_A = Number of shares owned by Harry = 1,000

N_E = Total number of existing shares = 4,000

N_N = Total number of new shares = 2,000

Diluted shareholding of Harry = 1,000 ÷ (4,000 + 2,000)

Diluted shareholding of Harry = 1,000 ÷ 6,000

Diluted shareholding of Harry = 0.17%

Before the dilution, Harry’s shareholding was 0.25% but afterward, his shareholding reduced to 0.17%. This means Harry’s shareholding was reduced by 0.08%

Example two

Assuming Joy purchased shares from a solar panel manufacturing company who have granted twenty thousand (20,000) restricted shares to their employees which will vest in two (2) years. If Joy’s shares are forty thousand (40,000) out of the one hundred thousand (100,000) existing shares of the company. We can calculate, using the diluted shareholding formula, what her diluted shareholding will be in two years when the restricted shares which have been granted to the employees will be vested.

Diluted shareholding of Joy = N_A ÷ N_E + N_N

N_A = Number of shares owned by Harry = 40,000

N_E = Total number of existing shares = 100,000

N_N = Total number of new shares = Granted restricted shares = 20,000

Diluted shareholding of Harry = 40,000 ÷ (100,000 + 20,000)

Diluted shareholding of Harry = 40,000 ÷ 120,000

Diluted shareholding of Harry = 0.33%

But in order for us to understand the extent to which Joy’s shareholding will be affected, we need to calculate her current shareholding using the shareholding formula

Shareholding of Joy = N_A ÷ N

N_A = Number of shares owned by Joy = 40,000

N_O = Total number of existing shares = 100,000

Shareholding of Joy = 40,000 ÷ 100,000

Shareholding of Joy = 0.40%

Based on the above, we can see that Joy’s shareholding will decrease from 0.40% to 0.33% if the restricted shares were granted to the employees’ vests in two years.

Example three

Suppose Joe owns five thousand (5,000) shares out of the ten thousand (10,000) total existing shares of Gray’s fast foods. Assuming Gray’s fast foods want to open a new outlet but do not have enough money and decides to issue five thousand (5,000) new shares to raise capital for this new venture. If their current share price is ten dollars ($10) per share and the new shares will be issued at twelve dollars ($12) per share, we can calculate Joe’s shareholding dilution and the shares price dilution using the diluted shareholding and diluted share price formulas respectively. We will however begin by calculating Joe’s current shareholding in Gray’s fast foods.

Shareholding of Joe = N_A ÷ N

N_A = Number of shares owned by Joe = 5,000

N_O = Total number of existing shares = 10,000

Shareholding of Joy = 5,000 ÷ 10,000

Shareholding of Joy = 0.50%

Now that we know Joe’s current shareholding, we can proceed to find out the shareholding dilution

Diluted shareholding of Joe = N_A ÷ N_E + N_N

N_A = Number of shares owned by Joe = 5,000

N_E = Total number of existing shares = 10,000

N_N = Total number of new shares = 5,000

Diluted shareholding of Joe = 5,000 ÷ (10,000 + 5,000)

Diluted shareholding of Joe = 5,000 ÷ 15,000

Diluted shareholding of Joe = 0.33%

From the above, Joe’s shareholding was 0.50% but decreased to 0.33% after the issuing of new shares, meaning that his shareholding in Gray’s fast food decreased by 0.17% due to the new share issue.

We can now calculate the diluted share price using

Diluted share price = [(C_P x N_E + P_N X N_N) ÷ (N_E + N_N)]

C_P = Current price of existing shares = $10

N_E = Total number of existing shares = 10,000

P_N = Issue price of new shares =$12

N_N = Total number of new shares = 5,000

Diluted share price = [($10 x 10,000) + ($12 x 5,000) ÷ (10,000 + 5,000)]

Diluted share price = [($100,000 + $60,000) ÷ 15,000]

Diluted share price = $160,000 ÷ 15,000

Diluted share price = $10.67

From the above, we can see that although the issuing of new shares reduced Joe’s shareholding percentage in Gray’s fast foods, it affected the share price positively since he bought his shares at $10 per share but now the diluted share price is $10.67 per share; translating to an increase of $0.67 on each share he owns.

Example four

Assuming a software development company has five hundred (500) existing shares which were issued at thirty dollars ($30) per share and decided to issue three hundred (500) new shares at twenty-eight dollars ($28) per share. If Jane was the company’s biggest investor and owns four hundred (400) shares before the new shares were issued, we can calculate her shareholding before and after the stock dilution and also, the diluted share price.

Diluted share price = [(C_P x N_E + P_N X N_N) ÷ (N_E + N_N)]

C_P = Current price of existing shares = $30

N_E = Total number of existing shares = 500

P_N = Issue price of new shares =$30

N_N = Total number of new shares = 500

Diluted share price = [($30 x 500) + ($28 x 500) ÷ (500 + 500)]

Diluted share price = [($15,000 + $14,000) ÷ 1,000]

Diluted share price = $29,000 ÷ 1,000

Diluted share price = $29

From the calculation above, we can see that the share price got diluted from $30 per share to $29; meaning that Jane has lost $1 on each share she owns.

We can calculate her shareholding before the share dilution using:

Shareholding of Jane = N_A ÷ N

N_A = Number of shares owned by Jane = 400

N_O = Total number of existing shares = 500

Shareholding of Joy = 400 ÷ 500

Shareholding of Joy = 0.80%

Having known Jane’s current shareholding, we can proceed to find out her diluted shareholding using

Diluted shareholding of Jane = N_A ÷ N_E + N_N

N_A = Number of shares owned by Jane = 400

N_E = Total number of existing shares = 500

N_N = Total number of new shares = 500

Diluted shareholding of Jane = 400 ÷ (500 + 500)

Diluted shareholding of Jane = 400 ÷ 1,000

Diluted shareholding of Jane = 0.40%

From our calculations of Jane’s shareholding before and after the issuance of new shares by the software development company, we can see that her shareholding reduced by half; from 0.80% to 0.40%.

Pros and cons of share dilution

A lot of investors immediately think about the reduction in their ownership stake when a company in which they own shares offers new shares for sale; this should however not be the case as there are some benefits attached to share dilution. We shall have a brief outline of these pros and cons within the table below and further discuss them hereafter.

Pros	Cons
Shareholders may experience capital gains in the long run.	Shareholders will have reduced voting rights after a dilution.
More capital is available to the issuing company to fund new projects.	There will be a reduction in the market value of the shares.
The distributions shareholders receive could be increased if the company makes more profits.	The earnings per share might be negatively affected.

Diluted shares pros

1. Capital gains
2. Availability of funds for projects
3. Increase in distributions

Capital gains

Although most shares that have undergone a dilution experience a downward spiral in price due to the influx of new shares into the market. In the long term, however, this is most likely going to change with the share price increasing. When this happens, the shareholders will experience capital gains especially if they sell at that period.

Availability of funds for projects

Companies that issue out more shares will have an availability of more funds to fund more projects in the company such as the initiation of new growth opportunities. If these projects are carried out well and achieve success, they could lead to business expansions and a likely increase in the company’s cash inflow.

Related: Free cash flow

Increase in distributions

Although issuing companies will have more shareholders after a stock dilution, there is still a chance that these shareholders will receive higher dividends than were formally available. The increase in distributions is more certain if the company makes more profits than before due to its increased revenue base.

Diluted shares cons

1. Reduction in voting rights
2. Reduction in market value
3. Reduction in earnings per share

Reduction in voting rights

Dilution of shares typically leads to the reduction in the ownership stake of each shareholder, consequently, it translates to lower voting rights too. As the voting rights are now shared between the previous and new shareholders which means their influence on the company’s decisions in matters that require voting will be reduced.

Reduction in market value

The laws of demand and supply will have an impact on the market value of the shares. When there is greater availability of the shares due to the share dilution, the share market value is likely to decrease in the interim as demand might not match the high supply rate.

Reduction in earnings per share

With the increase in shareholders, if the company’s profits do not increase, it means that the same dividends that were distributed between a few shareholders now have to be distributed to a larger pool of shareholders. As a result of this, the earnings per share will be negatively affected.

Share dilution vs stock split

Although both share dilution and stock split lead to an increase in a company’s outstanding shares, they have other inherent similarities and differences which we shall discuss below but before then, let us understand what stock split means.

Similarities between share dilution and stock split

1. Share dilution and stock split both lead to an increase in the company’s outstanding shares.
2. Both processes are initiated by the companies that issue the shares.
3. The shareholders cannot stop either share dilution or stock split from occurring.
4. Both could lead to a decrease in share price.

Share dilution vs stock split differences

Share dilution	Stock split
Shares are usually offered to new investors	Shares that result from a split are still owned by the same shareholders
Share dilution has no types	Stock splits are of two types; the forward stock split and the reverse stock split.
There is a reduction in both the ownership stake as well as the voting rights of shareholders	Neither the ownership stake nor the voting rights of shareholders are affected
The earnings per share are likely to reduce after a share dilution	Earnings per share remain unchanged.
The company’s market capitalization increases due to the increase in outstanding shares.	Although the number of outstanding shares increases, market capitalization remains the same.

FAQs on Dilution of shares

Conclusion

Diluted shares commonly have cons to investors in the short term which could translate to pros in the long run. A good business model and effective use of the additional capital available to the company after a share dilution could translate to massive benefits to both the company and its shareholders. Companies should therefore ensure that proceeds from share dilutions are effectively managed and efficiently used to achieve the best results.

Investors who want to invest in a company through the purchase of new shares and already existing shareholders in a company undergoing a share dilution should understand why the company is offering new shares. They should also understand how it will impact them as existing shareholders or new investors.

Using the diluted shareholding formula and the diluted share price formula, existing shareholders can ascertain to what extent their shareholding and the share price have been affected.

Overall, whether you are a company, shareholder, or investor, share dilution presents both pros and cons. It is therefore pertinent that you carry out additional personal research before deciding on diluted shares.