What is dilution? Dilution occurs when a company issues out more shares to the public, at less than the market value of the company. So lets say that if stock XYZ is trading at $100/share, any other shares that enter the market which the company receives cash of less than $100/share will have a dilutive effect on the company's stock. So, if XYZ issues out stock options priced at $10/share to their employees, whenever those options get exercised, there will be a net dilution to the company of roughly $90/share.
Why do companies dilute their shares? The two primary answers involve employee stock options, and buyouts/mergers involving stock swaps.
In the case of a stock swap/merger, the larger company issues out shares in exchange for the smaller company's shares. In most cases, the company that is being bought out has a book value far less than what it is being bought out for - the dilution is the market value of the stock issued minus the book value of the acquired company. The rest is entered as "Goodwill" in the balance sheet of a company.
Everybody knows about employee stock options: They are issued to employees at some price (usually less than the market value of the company) so that employees have an incentive to work harder in order to get the company's stock price up. Both sides win - the company and the employee. Not only that, but with current accounting methods, the issuance of stock options are not considered a cost to the company. In theory, the company could just forgo any cash salaries and issue stock options. This way, the company can report higher profits, as they do not have to deduct the cash salaries to their employees.
Who really pays for the employees then when a company decides to issue stock options? The existing shareholders do when they have their ownership in the company reduced. I am not implying that stock options are bad - when a company can increase its profitability at a rate greater than the dilution, then generally speaking the dilution is acceptable by the shareholders. However, when options are issued rapidly beyond prudence, the shareholders suffer badly.
An example: Amazon
I will be looking at Amazon between July 31, 1997 and July 31, 1999. Amazon split 2:1 and 3:1 between those time periods, and I have accounted for this. I have obtained this information by looking at previous SEC filings which you can access by clicking on the two dates above.
Over this time period, what happens to somebody's ownership of the company? Lets assume that you owned 25% of Amazon on July 31, 1997. What would happen to your ownership stake in the company after two years? Also, lets just pretend that Amazon actually made $200 million a year for the trailing 12 months behind those dates, and issued it out directly to their shareholders in a dividend. This is the chart of data we get:
The result of having an extra 25,449,963 shares of Amazon has reduced your net ownership in the company by 3.8%. However, in relative terms, that turns out to be a 15.2% dilution of your previous ownership. That 15.2% turns out to cut your dividend by 15.2%. So we can learn from this that shareholders ultimately pay for dilution. In order for our hypothetical owner to continue getting his original dividend, Amazon has to make 17.9% more income in 1999 than it did in 1997.
Question: What? You just said that the shares are diluted by 15.2%, but why do you need 17.9% more income to make up for it? Don't you just need 15.2% more income? Think of this: If you buy a stock and it sinks 50%, what gain from that point does the stock need in order to break even? Not 50%, but 100%. The math with dilution is similar. For those mathematically inclined, if a stock is diluted by a factor of x (lets say 0.152 = 15.2%), then the profit increase has to be ((1/(1-x))-1)% in order to break even with the dilution. If a stock is diluted 50%, you need to make a 100% profit increase in order to break even with the dilution.
A question which should be asked is: So what? That investment in Amazon has appreciated nearly 21 times during those two years even though the shares have been diluted. The answer is psychological: Amazon is perceived as making even more profits in the future in the past two years, and therefore its stock price has risen in greater proportion than the dilution. The problem is nobody actually thinks that when they put down $1,000,000 in Amazon stock today (which will buy 0.00315% of the company assuming a $31.7 billion capitalization) that they will continue to own 0.00315% of the company in five years when it will allegedly become profitable. The fact is that they won't. Assuming that Amazon keeps up a 5% dilution rate for the next 5 years, that person's investment will shrink down to around 0.00246% of the company. Even if Amazon turns out to be incredibly profitable in the future, wouldn't you want to be owning the same slice you paid for it today, rather then the smaller one you will have tomorrow? Whether this has been implicitly priced in the stock is a philosophical debate.
Shareholders pay for dilution. Shareholders have to trust management that when they give up 20% of their ownership in the company, that management will be able to deliver more than 25% of a return on their investment.