When a public company increases the number of shares issued, or shares outstanding, through a secondary offering, it usually has a negative effect on a share’s price and initial investor sentiment.

Become public

First, a company goes public with an initial public offering (IPO) of shares. For example, XYZ Inc. was successful in its IPO and is raising $ 1 million by issuing 100,000 shares. These are bought by a few dozen investors who are now owners, or shareholders, of the company. In the first full year of operation, XYZ generates net income of $ 100,000.

One of the ways the investing community measures a company’s profitability is based on earnings per share (EPS), which allows for a more meaningful comparison of company numbers. Thus, in its first year of public ownership, XYZ had EPS of $ 1 ($ 100,000 net income / 100,000 shares outstanding). In other words, each XYZ share owned by a shareholder was worth $ 1 in profit.

Secondary Supply and Dilution

Subsequently, things improve for XYZ, prompting management to raise more equity through a secondary offering in order to secure the capital needed for operations. This secondary offer is a success. In this case, the company issues only 50,000 shares, which generates additional equity of $ 50,000. The company then had another good year with net income of $ 125,000.

That’s the good news, at least for the company. However, seen from the perspective of the original investors, those who became shareholders through the IPO, as the shareholder base increased, their level of ownership declined. This consequence is called the dilution of their percentage of ownership.

In the second year, XYZ had 150,000 shares outstanding: 100,000 from the IPO and 50,000 from the secondary offering. These shares have a claim for $ 125,000 in earnings (net earnings) or earnings per share of $ 0.83 ($ 125,000 net earnings / 150,000 shares outstanding), which compares unfavorably to EPS of $ 1. of the previous year. In other words, the EPS value of the property of the original shareholders decreases by 17%.

How investor sentiment is affected

While an absolute increase in a company’s bottom line is a welcome event, investors focus on what each part of their investment produces. An increase in the capital base of a company dilutes the profits of the company because those profits are distributed among a greater number of shareholders.

Without a strong case for maintaining and / or increasing EPS, investor sentiment for a stock subject to potential dilution will be negative. And the prospect of stock dilution will usually hurt a company’s stock price. That said, there are ways for initial investors to hedge against dilution, for example, with contractual arrangements that restrict a company’s power to reduce an investor’s stake after subsequent rounds of funding.

The bottom line

Although IPOs are very exciting, they are not always the best way for an investor to increase his stock market wealth. When looking for investment opportunities, always pay attention to capitalization and dilution potential, and keep an eye on a company’s EPS.