Investing 101

Imagine a friend is coming over so you decide to order a large pizza and split it in half. However, another friend crashes the party and now 3 of you are sharing the pizza. Each person still gets pizza except the amount they get per person decreases.

You can think of shares in the same way. A stock dilution occurs when a company issues or creates new shares, causing the original shareholders percentage of ownership in the company to reduce. For any given value of a company, if you add one more share then there’s one more person “eating the pizza”. This negative impact on the value of a slice or share of a company is called dilution. 

The primary reason why a company would choose to dilute its shares would be to raise additional capital. Even though this move affects the current shareholders, it provides the company with the potential for higher profit, growth and eventually increasing the value of its stock. 

Unlike stock splits where the price of the share is adjusted to reflect the same percentage ownership, a stock dilution does affect the percentage of ownership a shareholder has in a company.  

For example: if company LMNO issues 100 shares to 100 shareholders, each shareholder has a 1% claim to the company. However, if LMNO were to issue 100 new shares to 100 different shareholders, this would result in stock dilution, causing each shareholder to only have 0.5% claim to the company. This would also have a negative effect on voting rights since each shareholder now has a smaller claim to the company, its assets and decisions. 

When a company issues or creates new shares, that causes the original shareholders percentage of ownership in the company to reduce.

Stock Dilution

Stock and Equity

## Stock Split

If a company wants to issue more shares but all its shares outstanding are owned, it can initiate a stock split. This is a decision taken by the company’s board of directors to increase the number of shares held by investors and in the stock market. For example, if a 2-for-1 stock split occurs, each investor with one share will receive an additional share at no additional cost. You might think what a steal? Well, not really. If a 2-for-1 stock split occurs, the price of the stock is also halved. As a result, there is no change in the market value of the company, there are only additional shares trading in the market. 

The primary objective of a stock split is to decrease the price of shares and make shares of the company more attractive to smaller investors. This increases liquidity and makes the company’s share price match other competitors in the industry. The reduced price per share can cause demand for the stock to increase, as this stock now looks relatively cheaper compared to before the stock split. 

## Reverse Stock Split

A stock split helps a company with a high share price decrease its price to make it look more attractive and a reverse stock split does the opposite. This allows companies with a low share price to increase their price, to avoid being delisted or seen as invaluable on the stock market. For example, in a reverse stock split of 1-for-3, 9 million outstanding shares at $0.50 each would become 3 million shares outstanding at $1.50 each. Similar to a stock split, the market value of companies remains unchanged. 