Continuing a discussion on the introductory article on financial terms and explanations, this article discussion common share dilution. Firstly, some background for EPS, let’s use a firm’s Net Income (NI), in this case on a per-share basis. The formula to derive this figure would be: Earnings per share (EPS) = NI / # of common shares. This changes when you consider distribution of Net Income, then the formula is: Net Income = Dividend paid to shareholders + Addition to Retained Earnings. When you consider the stock market: market price / earnings per share = P/E ratio.
Losing Shareholder Value in Share Dilution
EPS = NI / # common shares; EPS diluted < EPS basic; share dilution (loss in existing shareholders' value).
Let’s use an example to show how EPS dilution occurs. A fictitious company called General Ford wants to build a new facility to meet future demand of–vacuums. There is 1 million common shares and no debt currently (haha, you CAN tell it’s fiction). The current market share price = $5 –> market value =$5MM. Book value = $10MM –> $10 per share.
General Ford has experienced difficulties, including cost overruns, regulatory delays, and below normal profits. Market-to-Book ratio = 5/10 = 0.5. (Successful firms rarely have market prices less than book values.)
Net Income = $1MMI= –> EPS = $1 –> ROE = 1/10 = 10%
Price/earnings ratio (P/E ratio) = 5 (General Ford sells for five times earnings);
They have 200 shareholders, each of whom hold 5000 shares each; the cost of new plant = $2MM
Q. How many new shares should be issued?
General Ford has to issue 400,000 new shares ($2mm/$5) –> 1.4 MM shares after the issue
If ROE is fixed, NI is expected to go up by: 0.10 * 2MM = $200,000 –> Total NI = $1.2MM
What’s going to happen?
– EPS = 1.2/1.4 = $ 0.857 per share, down from $1 (1.2/1.2)
– The % of ownership of each old shareholder drops to 0.36% (=5,000/1.4MM) from 0.5%
-If P/E ratio is still 5, the market price will be $4.29 per share (=5*0.857), a loss of $0.71 per share
– Total book value = $12MM (=10+2) –> book value per share falls to $8.57 per share ($ 12MM/1.4MM)
There completes this fictitious example of General Ford and if they raise cash through the stock market by devaluing their common shares.