Frequently Asked Questions on Investing (Part 4) – Stock Dilution, Stock Split, Stock Buyback, Dividends

Stock Dilution, Stock Split, Stock Buyback, Dividends. Why companies take such actions? What are the pros and cons of each action? Why should I care as a retail investor?

Stock Dilution

Stock dilution or equity dilution happens when a company issues additional shares. This results in a decrease in existing shareholder’s ownership of the company, meaning the existing shareholder’s ownership is diluted.

Using a simple example, if a company has 10 shares and 2 investors each own 5 shares. Then each investor owns 50% of the company. The company issues 10 additional shares. Now, the total number of shares is 20. If a third investor buys the 10 additional shares, the first 2 investor will have their ownership of the company dropped from 50% each to 25% each. This is share dilution.

Why companies do this?

1. Raise cash. Cash can be used for operations, purchasing, repay debt, grow the company etc.
2. Renumeration to company employees or board members. Some companies pay their employees in both cash and stock options.
3. Payment for acquisitions or services. Companies can offer shares to other companies in exchange for services or when they buy out another company.

Impact of Stock Dilution to retail investors

It is generally viewed negatively by retail investors because it dilutes their shareholdings and thus indirectly affect the returns.

This is true ONLY if the following happens:

1)     The company is no longer growing. This means that if the company revenue stays constant, and the number of shares issued grow, then each share is worth less. This is very similar to inflation, where every dollar is worth less now because the federal reserve is printing large amount of currency. So, I wonder why no one is complaining about the dilution of currency, but are instead very happy receiving cash given out by the government.

2)     The number of shares issued outweighs the growth of the company. This means that if the company revenue is growing at 1 million annually, but issues 2 million additional shares annually. This means that each share is worth half of what it originally is.

Stock Split

Stock split divides the company shares into more shares. The end result is the total number of shares increase, but every shareholder still holds the same stake in the company.

Using a simple example, if a company has 10 shares and 2 investors each own 5 shares. Then each investor owns 50% of the company. The company announce a stock split of 2 to 1. Therefore, the total number of shares now is 20 as each share is split into 2 shares. Each investor of 5 shares will become 10 shares now, and the total ownership of each investor in the company is still 50%.

Why companies do this?

The company share prices has risen a lot. Each share is now very expensive and it is difficult for retail investors to buy in. The company wants to make the shares more affordable and easier to buy for retail investors who do not have a lot of capital. This will make the shares more liquid and more people can trade it, hopefully bringing up the price.

Impact of Stock Split to retail investors

It is generally viewed as positive by retail investors because it makes the stock more affordable for more retail investors and makes it easier to buy and sell options as each contract is worth 100 shares. This would in turn increase the liquidity of the shares and make it more tradable.

Stock Buyback

Stock Buyback is when the company announce that they have set aside some amount of cash to buy back the stocks that are outstanding in the market. The repurchased shares will be absorbed by the company and the total number of shares on the market will be reduced.

Using a simple example, if a company has 20 shares and 2 investors each own 5 shares, with the remaining 10 shares on the market, then each investor owns 25% of the company. The company announce a stock buyback of 10 shares. Therefore, the total number of shares available is 10. Each investor of 5 shares will give the investor a total ownership 50% of the company, up from 25%.

Why companies do this?

1)     The company has accumulated excess cash and feels that it is worth more than what the share price reflects, so it re-invests the excess cash on itself to generate benefits for all of the company shareholders.

2)     The company wants to issue stocks to its employees or stakeholders, but do not want to dilute all existing shareholders by doing a stock dilution, so it buys back shares from the market and reissue them to employees or stakeholders.

Impact of Stock Buyback to retail investors

It is generally viewed as positive by retail investors because it reduces the number of stocks on the market. This in turn increases the ownership of each shareholder in the company. Typically, this would result in an increase in share price of the company.

There are also tax implications involved in share buyback in certain tax jurisdiction. However, I will not explain this as I am not familiar with the tax code of different countries. You can approach your financial planner for more details.

Dividends

Dividends are cold hard cash paid out by the company directly to shareholders. They are generally profits from the company businesses and the company wants to share the profits with their shareholders. The decision to pay dividends to shareholder lies with the company. The company also decides on the amount and the time it will pay the dividends. Some company pays dividends on a quarterly basis, some bi-annual, and some on an annual basis.

Why companies do this?

1)     The company has accumulated excess cash and is unable to use it in a meaningful manner, so it pays it back to the shareholders to reward them.

2)     The company believes in sharing profit with its shareholders.

3)     In certain cases, the company is required by law to pay out its profits in the form of dividends. (e.g REITS).

4)     The company wants to enjoy certain tax benefits.

Impact of Dividends to retail investors

Dividends are the best kind of returns for retail shareholders. It benefits shareholders directly as it is cash and it helps shareholders recycle their capital without touching their invested principal sum. However, in some jurisdiction, the dividends are taxable. This would have to be factored in. Stock prices will also generally drop after a dividend exercise as the company free cash is reduced after dividends payout.

My Take:

My primary investment objective is to obtain steady cash flow, so I very much prefer dividend paying stocks. However, dividend payment must be sustainable, the company dividend payout should not be greater than their revenue and free cash flow, otherwise they are cannibalizing other parts of the business which will not be sustainable.

My secondary investment objective is to grow my investment capital. I will go for growth companies. Typically, fast growing companies do not pay dividends because they will reinvest their free cash flow and revenue to grow their business. In such situations, dividends matter less, stock split and stock buybacks are bonuses. Stock dilution will be something to watch. If the business is growing faster than they can dilute the stocks, then I will still accept the risk.

@TigerStars