Anybody who's ever divvied up a pizza understands that the more
people at the table, the thinner the slices need to be to
accommodate everyone. You don't have to love pizza like I do to
understand this principle. It's the same with stocks. The more
shares outstanding, the smaller the stake in the company each share
But most investors don't track the outstanding share count of the
stocks they hold, and that can spell big trouble.
Between 2000 and 2004, the share count for
JDS Uniphase (Nasdaq: JDSU)
doubled from 90 million to 180 million. That's the same as if the
2-for-1. You know what happens to a stock's price after a split --
it gets cut in half. And well it should, your stake in the business
gets cut down the middle.
JDS Uniphase wasn't (and still isn't) profitable, but to
illustrate, let's assume it maintained annual
of $180 million. In that case, doubling the share base would cause
earnings per share to slide from $2 to $1. If the market is only
willing to pay a certain multiple per dollar of profits (say, 20
times earnings), then we can reasonably expect the share price to
drop by half -- you can't escape the cold laws of math. The stock
actually hemorrhaged more than 98% of its market cap during the
years in question.
Simply put, if each share represents a smaller ownership claim than
it did before, then investors won't pay quite as much for it --
regardless of whether the business is worth $10 million or $10
billion. So putting new shares into circulation is a sure-fire way
to erode the value of a stock.
There are several ways this happens. Maybe a company is lavishing
its top executives with stock options that are later exercised. Or
it could be the result of convertible bonds, preferred shares or
warrants being exchanged for common shares. Or perhaps it was just
a secondary stock offering to raise cash; we've seen plenty of
those in the past year.
Unfortunately for investors, you won't see the dilution data
publicized much. Companies are quick to tell you how much money
they invested in repurchases, but rarely mention the other side of
For example, between June 2002 and June 2005,
Microsoft (Nasdaq: MSFT)
cheered itself for spending $18 billion to buy back 674 million
shares. But at the end of the three years, there were just as many
shares outstanding as the beginning. Why? Because the company
issued 666 million new shares during the same period. In other
words, it was repurchasing shares with one hand and doling them out
with the other.
And then there are companies who treat their shares as a form of
for acquisitions. Networking giant
Cisco Systems (Nasdaq: CSCO)
went on a major shopping spree in the "Dot.com" era, buying up
dozens of smaller rivals. Instead of paying the old-fashioned way,
the company simply handed out 1.7 billion new shares between 1996
and 2002. For the most part, little regard was given to valuation
-- easy to do when you're spending somebody else's money. In the
end, CSCO shareholders paid the price when the value of those
acquisitions was later written off one by one. Meanwhile, CSCO
shares have been stuck in neutral since the tech crash.
But the most toxic are cash-strapped companies with no choice but
to give equity stakes to bondholders or sell new stock on the open
market just to keep the lights on and the doors open.
Whatever the cause, the issuance of new shares is dilutive to
existing investors. With all this in mind, the companies in the
table below have ballooning share counts -- and disappointed
2007 Fully-Diluted Shares (Millions)
2008 Shares (Millions)
2009 Shares (Millions)
Current Shares (Millions)
% Change 2007-Present
|YRC Worldwide (Nasdaq: YRCW)
|Excel Maritime (
|Hartford Financial Group (
By itself, an increase in the number of shares isn't always a
reason for panic. Sometimes there are extenuating circumstances --
the entire financial sector has been forced to recapitalize in the
wake of the subprime meltdown. And there are always growing
Apple (Nasdaq: AAPL)
that have issued plenty in recent years and still rewarded
The key is to gauge how effectively a company is deploying the
proceeds -- returns on invested capital (
) can be a good start -- it measures how well a company puts its
capital to use. Those in the table above rank poorly by that
measure and have other red flags that warrant caution.
YRC Worldwide, for example, just orchestrated a $537 million
equity-for-debt swap to stay afloat. E*Trade just completed a
secondary stock offering and has over $1 billion in convertible
bonds that will soon be exchanged for common shares.
Action to Take -->
If you own any of the stocks listed above, you might consider
selling as your position has been heavily watered down... and that
means the value of your holdings has eroded. All things equal, I
prefer larger slices of stable companies loaded with meaty assets
and cash flows instead of seeing those shares become worth less and
-- Nathan Slaughter
Nathan Slaughter, Chief Investment Strategist of Market Advisor and
The ETF Authority, has developed a long and successful track record
over the years by finding profitable investments no matter where
they hide. Nathan's previous experience includes a long tenure at
AXA/Equitable Advisors, one of the world's largest financial
planning firms. He also honed his research skills at Morgan Keegan,
where he managed millions in portfolio assets and performed
consultative retirement planning services. Read more...
Disclosure: Neither Nathan Slaughter nor StreetAuthority, LLC
hold positions in any securities mentioned in this article.
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