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Perhaps the most important thing to remember about a diluted share is that you will earn less on your stock investment; that is, you will receive diluted earnings per share (DEPS). When investors want to assess the fiscal health of company, one of the most important measures is stock price. Publicly traded companies release financial statements on a quarterly basis that often report their earnings on a diluted share basis. In an effort to raise additional capital, corporations may issue additional stock shares, thereby diluting the value of each share already on the market.
Shareholders try to build wealth by buying shares of stocks. Those shares are how the stockholder lays claim to a corporation’s assets and earnings. A stock holder’s level of ownership in a company is determined by the number of shares that person owns relative to the total number of shares the company has on the market. A diluted share reduces shareholder equity.
Common stock allows the holder to attend and vote at shareholders' meetings and to receive profit dividends. Preferred stock holders generally cannot vote but they enjoy a higher claim on earnings, they receive dividends before the common shareholders and they have priority if a corporation goes bankrupt. For stock holders, the diluted share is not desirable.
For example, let’s say you own stock in the fictitious ABC Mutual Savings Bank, which has 1 million shares of stock trading at $10 US Dollars (USD) each. If the bank decides to issue another 1 million shares, then the value of your holdings would drop to $5 USD per share because of the added shares. Those outstanding shares can be issued in a variety of ways, such as converting preferred shares to common shares or giving stock options to company executives, managers and general employees as a form of compensation.
A company’s earnings per diluted share would most likely be lower than its basic earnings on each share of common stock. That’s because the price for a diluted share usually represents the worst-case scenario. It indicates what the value would be if all the investors holding options on those outstanding shares were to exercise them at once. Earnings per share is calculated by dividing a company’s profit by the total number of shares outstanding.
Banks tend to dilute shares to spread losses over a greater pool of shares or to bring in a fresh jolt of capital. Investors generally see share dilution as a bad sign financially, but the process can be helpful, however, if the company is planning to acquire another business or expand its operations or investments in some way.