Introduction
Dilution occurs when a company issues more shares, reducing the ownership percentage of existing shareholders. It is a critical concept that many investors ignore.
Explanation
Sources of dilution: 1) Issuance of new shares for financing, 2) Employee options (stock options), 3) Convertible debt. Dilution reduces EPS, dividend per share, and your ownership %.
Formula
Dilution % = (New Shares / Previous Shares) × 100
Example
Startup Tech: - You have 10% of a company with 10M shares (1M yours) - Company issues 5M new shares for financing - Total now: 15M shares - Your share: 1M / 15M = 6.67% (33% dilution)
How to read it
1-3% annual dilution due to employee options is normal in tech. Dilution > 5% per year is excessive. Mature companies (Apple, Microsoft) use share buybacks to offset option dilution. Loss-making companies tend to dilute aggressively. Red flag: constant dilution without earnings growth = value destruction.
Key takeaways
- Dilution reduces your ownership %
- Sources: issuance of shares, options, convertibles
- Dilution 1-3% annually is normal in tech
- Dilution > 5% per year is excessive
- Share buybacks offset dilution
- Dilution without growth = destruction of value