What Is Stock Dilution?

Stock dilution occurs when company actions reduce the ownership percentage of current shareholders. "Dilutive stock" is any security that generates this reduction. Although it is a common practice for distressed companies to dilute shares, the reason why a diluted stock has negative connotations is quite simple: A company's shareholders are its owners, and anything that decreases an investor's level of ownership also decreases the value of the investor's holdings. Dilution can happen in any number of ways. The news is usually broken during investor calls or in the offering of a new prospectus.

For example, if a company had a total of 1,000 shares on the market and its management issues another 1,000 shares, the owners of the first 1,000 shares would face a 50% dilution factor. This means that the investor-owned shares are worth half as much. This does not necessarily mean the dollar amount of the investment changes, but since the shares are worth half as much, the investor has significantly less pull in the company's decisions.

In a real-life example, consider the secondary offering made by Lamar Advertising (NASDAQ: LAMR) in 2018. The company decided to issue more than 6 million shares of common stock, diluting then-current holdings of 84-million shares. The stock price dropped nearly 20% before experiencing any significant rebound.

Although a secondary offering is not usually good for the investor, it can inject the company with the capital necessary to restructure or pay off debts. In the end, this is actually good for the investor, as the company becomes more profitable, and stock price rises.

When a company issues convertible debt, it means that debt holders who choose to convert their securities into shares will dilute current shareholders' ownership. In many cases, convertible debt converts to common stock at some sort of preferential conversion ratio. For example, each $1,000 of convertible debt may convert to 100 shares of common stock, thus decreasing current stockholders' total ownership.

The effect on the investor who held common shares prior to the dilution is the same as a secondary offering, as their shares are worth less as new shares are brought to market.

Convertible equity is often called convertible preferred stock. These kinds of shares usually convert to common stock on some kind of preferential ratio–for example, each convertible preferred stock may convert to 10 shares of common stock, thus also diluting ownership percentages of the common stockholders. Again, this has the same effect on the original, common-stock shareholder.

When exercised, certain derivatives instruments are exchanged for shares of common stock that are issued by the company to its holders. If you own a "call" option for Apple at $300 and the stock touches $300 during your options expiration period, you can "exercise" your right to convert your options into common stock at $300 a share. This is the most common occurrence of stock transference via derivatives, but more information about dilutive stock, options, warrants, rights, and convertible debt and equity can be found in a company's annual filings.