Dilution and Anti-Dilution
Dilution refers to a dilution (lowering) in earnings per share or book value
per share caused by issuance of additional shares or options.
When companies issue stock options, your share of earnings is diluted. This
is not a concern if the number of stock options is relatively small and
represents fair compensation and incentive pay for executives. However,
investors need to wary of management that rewards itself with obscene and obese
amounts of stock options. JDS Uniphase is the worse case I know of. In 2000 the
president was awarded a staggering (sickening to me) 9.6 million stock
options.
I personally would tend to simply avoid investing in a company that does
this. Warren Buffett reportedly believes that it is important that you trust
management. I don't trust those managers (the hired help really) who appear to
be attempting to grab an unfair portion of the company away from its
owners through excessive compensation (granted to them by compliant boards of
directors who are supposed to be looking after the owner's interests).
This is why my reports discuss management compensation.
Dilution also generally occurs every time a company issues shares. When your
company issues new shares your earnings might be diluted but your book value
will actually often be increased (anti-diluted). If a company with a high price
earnings ratio issues shares that will usually increase the book value per
share. For high tech companies with high share prices, it is a very smart move
for the company to issue shares. This may dilute your earnings (or losses) but
usually substantially increases your book value per share. This moves puts cash
in the bank and can put a floor under the stock price since the shares will not
usually decline below their cash value per share. In my opinion Nortel made a
huge error by not issuing shares for cash when the price was high. Instead they
issued hundreds of millions of shares for what (it seems) amounted to worthless
junk. A few $billion in the bank would have protected the stock price.
In purchasing an IPO you are usually subject to dilution in book value. You
may be paying $10.00 for a share that has a after IPO book value of $1.00 (90%
dilution). In some respects this is irrelevant, if the company is worth $10.00
per share based on earnings, then the fact that the book value is $1.00 will
never be a concern. But if earnings falter you have almost no book value to fall
back on. I get nervous when an IPO dilution is too high. If you organize a
successful company, I don't expect to get shares for book value but I'm pretty nervous
paying say more than double book value.
The IPO is how some company organizers get rich without ever actually making
a cent. They invest say $1 million. Then they convince the world to buy say 25%
of their company for say $10 million. Voila, the 75% that they paid $1
million for is suddenly worth $30 million. They quietly sell off an additional
25% of the company to investors for $10 million more . Now they have extracted
$9 million in profit on their $1 million investment and they still own 50% of
the company. The $9 million profit came from investors and not from earnings.
Now, even if they never earn a dime and the stock price goes to zero, they still
have $9 million in their pockets. Nice work if you can get it. In reality it's
not usually that easy and it's not easy to convince investors to pay inflated
prices. But in the dot com error this formula was repeated daily.
In the IPO case the company founders benefited from anti-dilution. They might
sell a stock with a book value of $1.00 for a price of $10.00. The dilution
suffered by investors is to the benfit of the company founders. After the IPO
with ash in the bank the company shares will have increased in book value. For
example start with $1 million shares with book value $1 dollar each. Sell $1
million shares for $10 million. Now the book value is $11 million / 2 million
shares = $5.50 per share. IPO investors suffer $4.50 in dilution while the
company founders gain $4.50 per share in anti-dilution. It's all fair if the
company can live up to its potential.
Shawn Allen, CMA, MBA, P.Eng.
InvestorsFriend Inc.
January 11, 2002
www.investorsfriend.com