How share dilution affects penny stocks

In a previous article, we discussed the importance of a company's share structure. We defined diluted shares as the number of common shares outstanding plus the number of convertible options that could become common shares outstanding. Those options include warrants, convertible bonds, stock options, etc.

Companies issue these options a number of ways:

  1. As incentive to buy the company's initial public offering (IPO). For example, when you buy a share of the IPO, you receive one common share and one warrant.
  2. As incentive to join the company itself. Companies will offer employees, especially upper management, stock options.
  3. As a means to raise capital (most often). When a company offers these options, they receive money on the options' exercise.

Diluted shares foretell a lot about a company's future, especially a smaller company. Dilution skews financial metrics, which lessens the value of each share. Let's consider an example:

  • Company A has 10 million shares outstanding. The company earned $2 million last year, for an earnings per share (EPS) value of of $0.20. With no dilution, the company's EPS value directly effects earnings growth.
  • Company B has 10 million shares outstanding. The company earned $2 million last year, for an earnings per share (EPS) value of $0.20. The company has 5 million options outstanding. Say all of those options are exercised; the company now has 15 million shares outstanding with an EPS value goes of $0.13. Simply put, each share is worth less once the options are exercised.

For Company B to have an EPS value of $0.20 again, it now has to earn $3 million. In other words, for its EPS to be where it was, its earnings would have to grow by 50%. On the other hand, if Company A's earnings grew 50%, to $3 million, its EPS value would grow 50% as well, to $0.30.

In order to account for possible share dilution, first see if the company reports its diluted shares. In a company's financial statements, there is a basic shares figure. Right under basic shares, there is typically a diluted shares figure, if there are any diluted shares.

Then, when determining a company's value, use its diluted shares. That way, you have an understanding of the company's current value and its potential value if its options were exercised. So, going back to Company B, look at the metrics for the basic shares (10 million) and diluted shares (15 million). You would see that the company has a current EPS of $0.20, but a fully diluted EPS of $0.13. How does this EPS compare to like companies? How does it affect future growth?

Next, ask management about plans for future dilution, or how they intend to control/limit future dilution. Management will likely never say, "we plan on diluting our shares," but they could say they intend to raise capital, etc. It's always good to see where management stands on possible issues concerning share value, especially when it comes to dilution.

Diluted shares are not always detrimental to a company's stock. However, it is important to know if there are diluted shares, how many there are and how they will affect the company's value. We have recommended companies that have had diluted shares outstanding. A number of these companies have done considerably well despite being diluted. The key is understanding the company's value both basic and fully diluted, and trusting management to do the right thing when it comes to shareholders.