When investors evaluate a small company, sales and earnings usually receive most of the attention, but another number can have a major impact on long-term returns: shares outstanding.
Small cap stock dilution occurs when a company issues additional shares, reducing each existing shareholder's percentage ownership. A company can grow revenue, enter new markets and improve profitability while shareholders receive much less benefit than expected if the share count is rising at the same time.
For small companies, issuing stock is not necessarily a bad decision. The question is what shareholders receive in return.
Why Share Count Matters
Consider a company earning $2 million with 10 million shares outstanding. Earnings per share (EPS) are $0.20.
If earnings increase 25% to $2.5 million but the share count also rises 25% to 12.5 million, EPS remain $0.20.
The business grew, but the individual share did not.
That distinction is especially important with small companies, which often rely on equity offerings to fund expansion, acquisitions or ongoing operations.
A well-timed offering can create value. If a company issues 10% more shares to finance an investment that eventually increases earnings by 30%, shareholders may come out ahead.
Repeated dilution without comparable improvement is another story.
The Bowser Rating System Rewards Low Share Counts
Share count has long been part of the Bowser Rating System. One of the system's 13 points is awarded when shares outstanding are no greater than 10% of trailing 12-month sales.
A company with $50 million in annual sales, for example, would need 5 million shares outstanding or fewer to earn the point.
The advantage is straightforward. When a successful small company has relatively few shares outstanding, improvements in the business are spread across a smaller share base.
If two companies each earn $5 million, but one has 10 million shares outstanding and the other has 50 million, the first produces $0.50 per share in earnings compared with $0.10 for the second.
That alone does not make it the better investment. Valuation, debt, growth and other fundamentals still matter. However, a low share count gives improving results greater potential to show up on a per-share basis.
For a small company, that can be a significant advantage.
Share-count discipline is only one part of our fundamentals-first approach to evaluating stocks under $5.
A Recent Bowser Example
Village Farms International (VFF) shows why we continue to watch share dilution closely.
The company has delivered substantial improvement in its cannabis operations, including growing international sales and improved profitability. But in June, Village Farms issued another 7.5 million shares in a $15 million equity offering, bringing its outstanding share count to more than 120 million.
That does not erase the company's recent progress. The additional capital strengthened its financial position while Village Farms continues to invest in expansion. The high share count, however, remains one reason VFF does not receive the Bowser Rating System point for low shares relative to sales.
It is a good example of why we look at both sides. The business may be improving, but we also want to know how much of that improvement ultimately accrues to each share.
Not All Small Cap Stock Dilution Is Equal
Stock offerings are only one source of dilution. Investors should also watch warrants and options, convertible securities, stock-based compensation and acquisitions funded with shares.
Dilution can also change how we interpret insider buying, since insider purchases carry less weight when the company is simultaneously issuing substantial amounts of new stock.
Rather than treating all share issuance as negative, ask a simpler question:
What did shareholders receive in exchange for the new shares?
If management issued stock to fund a profitable expansion, strengthen a weak balance sheet or make a valuable acquisition, the trade may prove worthwhile.
If shares are continually issued simply to cover losses or fund projects that produce little return, existing shareholders can end up owning a steadily smaller piece of a business that is not becoming proportionately more valuable.
The longer-term trend is often more useful than any single offering. Compare today's share count with three or five years ago and then compare that increase with the company's growth in sales, earnings and cash flow.
Growth Per Share Still Counts
Small companies can grow rapidly because they are starting from a small base. That is one of the primary attractions of this part of the market.
A relatively low share count can magnify that advantage. A company does not need hundreds of millions of dollars in profit to produce meaningful earnings per share if its results are being divided among relatively few shares.
The opposite is also true. A continually rising share count forces the business to grow faster just to keep per-share results moving forward.
So when a company reports higher revenue or earnings, do not stop there. Check the share count.
For long-term shareholders, the best growth is not simply growth in the company. It is growth that reaches each share.
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