Share dilution: Be alert, not alarmed

The core of being a shareholder for most people is simple. As a part owner of a company you hope to benefit from receiving a share of the earnings of a company (dividends) and you hope that, over time, that company's earnings will grow and the shares you own will become more valuable. 

Of course, there is a risk that both of these might not happen, something that you need to be comfortable about as a shareholder.

A key input into benefiting from both the share of earnings an investor hopes to receive, and benefiting from the growth of company earnings over time, is the slice of the company that you own. As investors, I think that sometimes we lose track of how important our ownership slice of the company is. 

During the financial stress of the Global Financial Crisis, large numbers of discounted shares in companies were issued to raise money as companies struggled to get loans, often with little discussion of how issuing extra shares impacted on the existing shareholders. Overall though, it is important to note that the decision to issue extra company shares is not a good or bad decision by itself. The aim of this article is simply to raise this issue for investors, as something that they should keep their eye on.

Reasons for issuing new shares

It is worth starting this discussion on the issue of share ownership dilution by considering the reasons that companies might issue extra shares. Going to the very start of the decision, there are going to be times that companies will need to raise extra funds. 

Those funds might be needed for a variety of reasons, from expanding the business, to purchasing a new business, to paying for a significant asset. There are two core approaches that a listed company might take to raising funds; choosing between borrowing money (possibly through a bond issue or a bank loan), or issuing extra shares.    

There are, of course, pros and cons to both approaches. As an owner of a company you will be keen to see that debt levels (for example, the debt-to-equity ratio, or the interest-coverage ratio) remain modest while also not wanting to see so many extra shares issued such that your ownership stake in the company is diluted too much.

It should also be noted that making the decision to borrow money or issue new shares to raise funds is an entirely reasonable decision for a company to make. A key argument for owning shares is the possibility of benefiting from an increasing stream of earnings and dividends. To create growth, funds are needed to invest in new projects and new assets. Further, when the time is right companies might choose to buy back some of their shares. The decision to issue or buy back shares can be part of the decision making that is made to maximise shareholder returns.

At a practical level, key reasons that extra shares are issued include:

• through rights issues to all shareholders to raise more significant sums of money;

• as payments to executives; and

• as part of dividend reinvestment plans, where new shares are sometimes issued in place of cash payments for shareholders who elect to receive dividends in the form of additional shares.

A case study: NAB

National Australia Bank has now, for three years running, kept its dividend steady at $1.98 per year. This is, of course, better than cutting its dividend, but in the short term it does not meet the ambitions of shareholders who hope that dividends will increase over time. It is interesting to think about this flat dividend against the change in shares on issue for NAB over time.

The following table shows the change in shares for NAB over the two most recent financial years. 

Table 1: Number of ordinary NAB shares on issue for the last two years at September 30

Source: Extract from NAB's annual report (page 98)

The first financial year saw a significant increase in the number of shares on issue, a more than 10 per cent increase in the number of shares. Most of those extra shares came about through a rights issue, which set out to raise $5.5 billion in the middle of 2015.

The raising was done to improve the capital position of the business, in anticipation of regulatory change. Importantly for shareholders, the rights issue was structured in such a way that everyone was able to participate in proportion to their holding (it was a two-for-25 pro rata rights issue) and those people who did not want to, or who were not able to, buy extra shares still benefited from the rights issue as it was ‘renounceable' and people could sell their rights on the market, or have them sold on their behalf.

If we have a look at 2016 we can see that there are significantly less shares issued, with most shares issued through the dividend reinvestment program and the employee share plan. The extra shares issued amounted to less than 2 per cent of shares on issue.

Final word

The core of investing in shares remains the fact that we are part owners of a company, and the number of shares that a company has outstanding has an important impact on the dividends we receive, and the per share value of the company.

Being aware of this, and keeping an eye on how companies we invest in are issuing or buying back shares, provides us with a useful source of information about how the company is being run.