Share dilution and employee stock options

In simple terms

A share is a slice of a company. When the company creates new shares, there are more slices. Unless the company receives enough in return, each existing slice becomes a smaller part of the whole. This is dilution.

Dilution is not always bad. A company that sells new shares at a good price and invests the money well can make every shareholder better off. But dilution is easy to overlook, because headline profit can keep rising while each shareholder's share of it grows slowly, or even shrinks.

Ways the share count grows

Fresh issues to investors. A follow-on offer, a rights issue to existing shareholders, or a placement with institutions raises new money. A rights issue lets existing shareholders buy in proportion to their holdings, so those who take up their rights are not diluted.

Preferential allotments. Shares or convertible warrants issued to selected investors, sometimes including the promoters themselves. Check who receives them and at what price compared with the market.

Convertibles. Bonds or warrants that can be turned into shares later. They add to the share count when converted.

Employee stock options (ESOPs). Options given to employees to buy shares at a set price in future. They are a common part of pay, especially in technology companies, and each year's grants add a little to the share count.

Acquisitions paid in shares. Buying another company with newly issued shares rather than cash.

Measuring dilution

The simplest measure is the change in the number of shares over time.

Check the share count in each year's annual report or in the EPS note, and calculate its growth just as you would for revenue. The revenue and earnings growth lesson shows why per-share growth is the figure that matters to shareholders.

Diluted EPS

Options, warrants and convertibles that have not yet turned into shares may do so in future. Diluted EPS divides profit by the share count including those potential shares, so it shows what EPS would be if they were converted. Companies report both basic and diluted EPS. A large gap between them means a lot of potential dilution is waiting. The EPS lesson explains the calculation.

The cost of employee stock options

ESOPs are a real cost of employing people, even though no cash leaves the company when they are granted. Under Ind AS, companies charge an estimate of the options' fair value as an expense, called share-based payment, in the income statement.

Some companies present "adjusted" profit that adds this expense back. Be careful: if a company regularly pays staff partly in options, ignoring their cost overstates profit and understates the dilution shareholders bear. Compare the cash spent on buybacks with the shares issued to employees; some companies spend heavily just to keep the share count steady.

When dilution creates value

Issuing shares is not automatically harmful. It creates value for existing shareholders when the company receives more than the slice it gives away is worth.

• Issuing shares at a high price to fund investments with good returns can raise value per share.
• Issuing shares cheaply, for example below a fair value to selected investors, or to fund an acquisition that earns poor returns, transfers value from existing shareholders.

Questions to ask about any issue:

1. At what price, compared with the market price and your estimate of value?
2. To whom? Public investors, existing shareholders, or insiders?
3. For what? Debt repayment, growth investment, acquisitions, or simply to fund losses?
4. What return is the new money likely to earn?

Why it matters

Growth stories are often told in total numbers: revenue, profit, market value. Shareholders own slices, and only per-share numbers show what has happened to their slice. Companies that issue shares year after year can grow rapidly in size while delivering little to their existing owners. Tracking the share count is one of the simplest checks an investor can make.

Limitations

Share counts can also change through splits and bonus issues, which add shares without changing anyone's ownership; adjust for these before measuring dilution. Diluted EPS assumes potential shares are issued and ignores the cash received on exercise. And the value created by an issue depends on how well the money is used, which you can judge only over time.

Common mistakes

• Comparing total profit growth without checking the share count.
• Confusing bonus issues and splits with dilution. They change the number of shares, not ownership.
• Ignoring ESOP costs in "adjusted" profit.
• Assuming all share issues are bad. Price and use of the money decide.

Try it yourself

Pick a listed company, preferably one that grants employee stock options.

1. From ten years of annual reports, note the number of shares each year, adjusting for any splits or bonus issues.
2. Calculate the share count's compound annual growth.
3. Compare the growth of net profit with the growth of EPS over the same period.
4. Find the share-based payment expense in the latest income statement or notes, and compare it with net profit.