The share price and company's secondary offering

When a company increases the number of shares issued, or shares outstanding, through a secondary offering it generally has a negative effect on a stock's price.

But what causes the change in investor sentiment? To explain, let's start from the beginning.

First, a company goes public with an initial public offering (IPO) of stock. For example, XYZ Inc. has a successful IPO and raises $1 million by issuing 100,000 shares. These are purchased by a few dozen investors who are now the owners (shareholders) of the company. In the first full year of operations, XYZ produces a net income of $100,000.

One of the ways the investment community measures a company's profitability is based on earnings per share (EPS), which allows for a more meaningful comparison of corporate figures. So, in its first year of public ownership, XYZ had an EPS of $1 ($100,000 of net income / 100,000 shares outstanding). In other words, each share of XYZ stock held by a shareholder was worth $1 of earnings.

Subsequently, things are looking up for XYZ, which prompts management to raise more equity capital through a secondary offering, which is successful. In this instance, the company only issues 50,000 shares, which produces additional equity of $50,000. The company then goes on to have another good year with a net income of $125,000.

That's the good news, at least for the company. However, when viewed from the original investors' perspective – those who became shareholders through the IPO – their level of ownership has been decreased with the increase in the shareholder base. This consequence is referred to as the dilution of their ownership percentage.

Some simple math will illustrate this event. 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 on $125,000 of earnings (net income), or earnings per share of $0.83 ($125,000 of net income / 150,000 shares outstanding), which compares unfavorably to the $1 EPS from the previous year. In other words, the EPS value of the initial shareholders' ownership decreases by 17%.

While an absolute increase in a company's net income is a welcome sight, investors focus on what each share of their investment is producing. An increase in a company's capital base dilutes the company's earnings because they are spread among a greater number of shareholders.

Without a strong case for maintaining and/or boosting EPS, investor sentiment for a stock that is subject to a potential dilutive effect will be negative. Although this isn't automatic, the prospect of share dilution will generally hurt a company's stock price.

(For related reading, check out Markets Demystified and What Is Dilutive Stock?)