Abu Dhabi Investment Authority said it will invest $7.5 billion in Citigroup Inc. Once the equity units Abu Dhabi bought are converted into stock in 2010 and 2011, Abu Dhabi will hold a 4.9 percent stake in Citi. Until those units get converted, Citi will pay Abu Dhabi a yield, or essentially an interest rate, of 11 percent. This is a hefty interest rate and also the analysts estimate earnings per share going forward will be diluted by about 3 to 4 percent by the sale. A very bad move for the investors more like the scenario 3 below.
What does all this mean to an average investor named Joe?
Stock dilution refers to when a company issues additional stock, for any purpose. Some of those purposes are bad for outside shareholders, some are neutral, and believe it or not, some are actually good. We examine all three scenarios to see how they can affect us as investors.
Example.
In 2005, Phaser(a hypothetical company) had 100,000 shares of common stock outstanding, a market cap of $1 million, and $100 of net profits.An individual investor Joe, on Dec. 31, 2006, bought 10,000 shares of Phaser stock. When the company reported its earnings, Joe was elated to learn that, by virtue of his stake, he vicariously earned $10 worth of Phaser's profits. Little did he know what 2007 held in store for him.
Dilution Scenario One
In 2007, Phaser decides to engage in the worst of the three main ways that companies dilute their shares: It issues 100,000 stock options to its CEO. For the time being, Phaser has a "basic share count" of 100,000 shares actually outstanding. But because its CEO will eventually exercise his or her stock options (i.e., tell the company to issue 100,000 shares to him or her and then sell them on the open market), Phaser now has a hypothetical, or "diluted," share count of 200,000.
That's bad news for Joe. While he will still own his 10,000 shares, his ownership stake will be diluted once the company issues that extra stock. What does that mean? Well, when Phaser's share count stood at 100,000, and it earned $100, Joe was entitled to 10% (10,000/100,000) worth of those profits, or $10.
But when Phaser issues those 100,000 extra shares, Joe's shares will not equal 10% but just 5% (10,000/200,000) of all shares outstanding. If Phaser earns $100 again the next year, Joe's take from that haul is just $5. Poor Joe.
The CEO, on the other hand, gets 100,000/200,000 worth of the profits, or $50. Lucky CEO!
Thus, the primary reason Fools dislike stock dilution is that it often represents a transfer of wealth from outside shareholders -- you and me -- to insiders.
Dilution Scenario Two
Stock dilution, however, isn't always bad. But before we look at when it can be good, let's consider the iffy situation of a company that acquires another one and pays for the purchase in stock. Say Phaser wants to expand its business. Phaser's solution is to buy out a rival.Since Phaser hasn't sold anything and doesn't have any actual, er, cash, it wants to issue its own stock to target company shareholders in exchange for their shares.
Now, if the target company has a market cap of roughly $32 billion. With Phaser shares trading for $10 a stub, our intrepid company will have to issue 3.2 billion new shares to acquire its heart's desire. Doing that will dilute Joe and Phaser's other shareholders thousands of times over. In what universe could that much dilution possibly be a good deal for Phaser shareholders?
The answer requires another question: Is Phaser overpaying for its purchase? If Phaser pays a price equal to target company's intrinsic value as a business, then the dilution created by the purchase does not really hurt Joe. Yes, Joe's slice of the merged Phaser pie looks much smaller than his slice of Phaser alone does. But the new pie is much bigger. Picture this: Joe is receiving a much thinner but also much longer slice of the (Phaser+Target) pie, in return for his original wide but stubby slice of Phaser.
And there's another possibility to consider. Alone, Phaser may not be objectively "worth" the $1 million market cap that the market accords it. If Phaser's stock is overvalued, then paying for an acquisition in inflated-value stock may be a smarter move than paying in cash.
Issuing More Stock through public offering or Convertible Bonds
When Phaser gives 100,000 shares to its CEO for a nominal "exercise" price, that's bad for outside shareholders. But what if, before Phaser decides to go that route, the message-board rumor mill gets going and anoints Phaser as the next moon-rocket stock? As Phaser's stock price doubles, triples, and then jumps 10 times more, company management reconsiders, decides not to issue options, and instead sells the 100,000 shares on the open market -- at $600 a pop.
If the company's intrinsic value hasn't changed, and if only its stock price has increased, then this is great news for Joe. After the secondary offering is completed, he again owns 10,000 shares out of 200,000, or 5% -- down from his original 10%. However, Phaser itself is now worth more -- not just from the rumor-bubble pricing of its stock but also intrinsically, because the company has traded 100,000 shares for $60 million in cash. That cash now sits in the company's bank account, and Joe owns 5% of it, or $3 million.
So to sum up, whenever a company issues shares at a price higher than the shares' intrinsic value -- whether it does so to buy another company or to sell the shares and raise cash on the market -- an outside shareholder benefits, despite his or her percentage of ownership being diluted.
The above article is courtesy MF
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