Exposing the Financial Risks for Shareholder Dilution
Shareholder dilution is a naughty term – to be only spoken of in hushed tones through the hallowed halls of high finance. Here, the corporation only exists to create value for shareholders, and purposeful dilution is sheer blasphemy. As the name would imply, shareholder dilution weakens ownership power.
All investors must identify the opening salvos for shareholder dilution, before committing capital to any going concern. Mature, productive businesses will proactively safeguard current shareholders against debilitating dilution.
The Corporation
A business concern files articles of incorporation with the secretary of state for an authorized number of shares. To finance itself, the corporation will issue debt to creditors and sell shares of common stock to equity investors.
Shareholders do have ownership rights above the corporation. Over the long term, share prices will closely parallel profit expectations, which do stretch between zero and infinity. For this, we assume that all corporate boards and executives work to generate and deliver real shareholder value.
Shares of Common Stock Outstanding
Shares of common stock outstanding, by itself, is an arbitrary balance sheet line item. We multiply the number of shares of common stock outstanding by current share price to calculate market capitalization. Market capitalization, in effect, is the price tag that Wall Street applies for the entire business.
Microsoft stock closed out its last, January 12, 2024, trading session at $388 per share, with 7.446 billion shares of common stock outstanding. On this date, Microsoft briefly surpassed Apple as the world’s largest publicly traded corporation, with a nearly unfathomable $2.9 trillion in market capitalization.
Shareholders, of course, are mostly concerned with profitability. Microsoft racked up $72.4 billion in profits through its fiscal 2023, for $9.72 in earnings per share ($72.361B net income / 7.446B shares = $9.72 EPS).
Shareholder Dilution
Shareholder dilution describes a dramatic increase of shares of common stock sold to outside investors, which lowers ownership percentages for the older individual shares of existing shareholders. A corporation might issue new stock to raise fresh capital, buy out competitors, convert bonds and preferred shares into common stock, and to also compensate employees through stock option grants.
Net income statements will list out both basic and diluted earnings per share – to account for stock options and convertible debt already on the books. For Microsoft, its 2023 EPS would have declined slightly, from $9.72 to $9.68, after increasing its 2023 share count by a planned 16 million.
Against this backdrop, it is BlackBerry that stands alone in infamy, for dilution and the subsequent destruction of shareholder value. On June 19, 2008, BlackBerry stock peaked at $147.55 per share, for $80 billion in market capitalization.
By 2024, BlackBerry stock had collapsed to $3.40 and a meager $2 billion market cap, after sharply increasing its share count from 500 million to 600 million through excessive stock options and wonton convertible debt. BlackBerry is in a death spiral and must tap capital markets for working capital to simply stay afloat, instead of generating sales and profits through its core operations.
In 2008, BlackBerry had won the battle for commercial handset market share, only to ultimately be routed in the Web 2.0 War to the likes of Apple, Microsoft, and Google. Shareholder dilution is a typical marker for a failing business desperate to raise cash by any means necessary.
Financial Strategy
Dilution is often times the beginning of the end and long-term investors should consider exiting immediately, when management shows a reckless disregard for shareholder value. Intelligent investors read tea leaves through the statement of cash flows. Here, the financing activities section will show both the proceeds from the issuance of stock and cash spent upon the repurchases of common stock.
Expect for a mature business to buy back its own stock – at the same time that it issues new stock to make good upon executive compensation and options grants.
Apple, of course, has taken this tried-and-true cash management practice several steps further. Apple has spent more than $600 billion over the course of the past decade to retire nearly half of its shares of outstanding common stock.
Apple EPS improved from $5.67 to $6.16 between fiscal 2021 and 2023, despite net income barely budging through this very same time frame. Apple stock responded in kind, by skyrocketing up 45% through calendar 2023.