I don’t understand something so maybe someone can help me with this:
Companies that wish to expand, or to buy another company etc. and that don’t have the cash for it do something called “secondary public offerings”, or SPOs. Basically, let’s say the company has 15M shares, priced at $11. They do an SPO by issuing - that is, creating out of nothing - 2M shares, and selling them on the open market or through underwriters. The price for those 2M shares is usually determined by the stock price a few days after the SPO announcement.
For some reason such an event usually results in stock price drop immediately after the announcement, and the explanation for it is usually that the SPO “dilutes” the share value. This is what I don’t understand. It’s not like the company creates 2M more shares and then gives them away - THAT would certainly be dilutive. But the company SELLS those shares, getting a fairly big chunk of cash for them, which adds to the value of the company, which removes the “dilution” completely. It’s just a value-neutral event, objectively (minus the underwriter fees, but that is a drop in the bucket, comparatively).
So my question is - are all the people who think that the SPOs “dilute” their shares incorrect and have no idea what is happening, or am I missing something?
Presumably, the owners of those secondary shares are going to be paid dividends from the company’s profits in the future. That money will therefore not be paid to the owners of the primary shares in the future, reducing the value of the primary shares. Remember, the point of owning shares is not only to sell them after they’ve gone up in value, it’s also to become a part-owner of the company and receive a share of the profits. That’s why we refer to stocks as “shares”. Owners of primary shares now believe that they will be receiving less in dividend payments, so some of them sell, and the value drops.
Well, SPOs usually are done by companies that are young and expanding, and paying no dividends currently. Apart from that, that extra chunk of cash that the company is getting is supposedly going to generate more revenue, thus increasing the total profits, thus being at least value-neutral for future dividends.
I mean, I could understand if on an SPO announcement the value of the shares would drop if shareholders thought that was a stupid move and rise or stay the same if the shareholders thought it was a good move. But it invariably drops. Always. Although sometimes it recovers in as short a period as a day. It’s that initial drop that I wonder about.
Follow-on offerings are often erroneously called secondary offerings. In the case of follow-on offerings, it is exactly as you said - the company simply creates more shares out of thin air and it is dilutive. Take a look at Javelin Mortage Investment Co. (ticker JMI). Yesterday they fileda follow-on offering of 6 million shares. Their current float is 7.5m shares. After this offering there will be 13.5 million shares in the float.
As to why stocks drop from true secondaries - hard to say. Perhaps people think that large holders selling stock is indicative of insiders knowing something they don’t and they decide to follow suit. Another possibility is arbitrageurs (well, kinda) shorting the stock with the expectation that the secondary will be priced below the current market price. They would then expect to cover their short position by subscribing to the offering.
Only if the new venture is as successful as what the company was already doing. If McDonald’s announced they were starting a new company that would make computers, maybe you’d want to invest, but I doubt you’d want to invest in shares at the same price as McDonalds shares. Its pretty unlikely a McDonalds computer company is going to be as valuable as the McDonalds fastfood company.
I think the same logic holds if McDonald’s was just giving a secondary offering to make computers within their existing company.
I assume the assumption of the market is that if there was something better a company could be doing with their capital, they would’ve already done it. If they’re raising capital for a new venture, they presumably don’t expect it to do as well, otherwise the new venture would’ve been the old venture.
Issue 1: SPOs are done by companies that don’t have money on hand and can’t get bank financing. This alone should explain a drop in stock value. Yes, the company always anticipates increased profitability, but people in the real world know that there’s no sure thing. Every bankrupt business in the world promised to be profitable. Ideally, shareholders want to own a company that is profitable enough to finance its own expansion and they put less value on the stock of companies that can’t do that.
Issue 2: If you believe that your stock entitles you to 2% of the voting rights and 2% of the future dividends, are you going to be happy if your stock now entitles you to 1% of voting rights and 1% of dividends? Yes, the company is supposed to be bigger and more successful, but bank financing can make the company bigger and more successful and still leave you with 2%. Most SPO’s give existing shareholder a right to buy in… but you’re still not happy that you have to double your investment just to maintain what you had before.
Issue 3: You say that the company now has double the assets, but this isn’t true. No company does an SPO just to pad their checking account. The company raised all that money and then spent it. This kind of brings us back to point 1 - we expect a return on that spending, but nothing is for sure. As an original shareholder, you are losing value right now, and you’re only gaining value in the future, maybe.
I am talking about something called “mixed shelf offering”. Which, AFAIU, is issuance of new shares and selling them (in principle at any time later, but in practice almost immediately).
The value for that offering has to come from somewhere. Otherwise, your asking new investors to spend money to buy nothing.
The value comes from the current total assets of the company. Using your numbers of 15 M at $11 each, that is an asset total of $165M. You are now suddenly creating an extra 2M shares, and selling them. What are you selling? A fraction of that Total Assets, currently $165M. Because that $165M is now divided among 17M shares, the value is $9.71 a share. As new shares are bought, that total assets line increases, and thus the per share value goes up accordingly, but in the moment of the offering, the share value is lower than the share cost. So the share cost has to drop to match the value. Ergo, the stock price drops, then climbs as more shares are bought.
Looking up “mixed shelf offering” on google, I find this.
A “shelf offering” is a type of Follow-on Offering - the company is selling additional shares of their worth. It is dilutive, as described by Trom and me. The “shelf” part means they are registering the security so the value effect kicks in but they may not sell the securities immediately - they may hold them back, or sell them incrementally. The “mixed” refers to the kind of securities.
A true Secondary Offering is a stockholder selling his shares to someone else, so that does not affect the value of the company stock shares directly because it does not change the total number of shares of the total assets, it just changes hands on some of those shares. Thus it is non-dilutive. However, other market forces may drive a change in stock price as a response to seeing high activity. If some large stakeholder suddenly starts selling a huge chunk of stock, people wonder what is up, what he knows, why he’s getting out.
I don’t think that works. When the new shares are created, the company owns 2 million shares of itself. If it sells a share, then it gets cash equal to that shares value. The effect on the companies total assets should be nil.
Not really. The better the company does (the less its cost of capital, in this case), the better the shareholder does. I just don’t see anything taken away from the shareholder. If the offering is, for simplicity’s sake, is 100%, then before the SPO the shareholder owns X% of the company. After, the shareholder owns X/2% of the company that is twice the size. How is this not neutral?
That’s right. Selling, not giving it away. If it was giving it away, it would be dilutive. Since it is selling it, thus increasing its own worth, how is it dilutive?
For most “young” growing companies, book value is a lot less than the share value. Thus, even if the company is doing the offering at a discount to the current share price, it is still selling the shares above book, thus lowering the price-to-book ratio of all shares. How is that not a positive?
Let me try to create an analogy (analogies suck, but here goes).
Say you have 5 friends and they decide to pool their money into one account, each with an equal share, and then invest that to allow it to grow. Each contributes $5 to the account, for an account total of 5 x $5 = $25.
They let the pot sit, it grows by $3, to a total of $28.
Now another buddy wants to buy in to the pot. But he is buying an equal share of the whole pot. So instead of splitting that $28 into 5 equal piles, you now sort it into 6 equal piles. The piles change from a value of $5.60 each to $4.67 each (6 x 4.67 = 28). If he is buying a slice of the existing pile, he is getting $4.67 in value. Why would he pay $5 or $5.60 to get $4.67 in value? Of course, as soon as he buys in, the overall pot value goes up from $28 to $32.67. Now everyone’s share is worth $5.45.
In the small numbers of my example, the guy’s $4.67 makes a big difference in the total balance, but if the incremental increase from his buy-in is tiny compared to the contribution of lots of buy-ins, that makes less of a difference. It would be more like he buys in for $4.67 and gets $4.68 in post buy-in value. He’s not going to pay $5 to get $4.68, which is the price until a significant number of buyers buy-in and raise the pot total.
If we look at the numbers from before, one share was worth ~$10. $10 is a tiny fraction of $165,000,000. The pot increase from that one purchase was negligible, but he still got that equal share of the pot.
Individual shareholders are losing control with each share sold. Control has value.
You have to seperate out in your mind what is good for the company (getting money) and what is good for the shareholders (having the company do well, that is, in this context, the company getting money AND having control over it/entitlement to dividends).
It may well be that, by offering shares, each individual share is “worth more” because the company has more money … but the cost is dilution of ownership.
Take an extreme example. Company A has two shareholders, one, Mr. X, with 51% and the other, Mr. Y, with 49% of the shares. Company B has the same.
Company A raises cash by creating and selling more shares. Suddenly, it has THREE shareholders - Mr. X, Y and Z. Whereas befire Mr. X was the majority shareholder and able to control the company, now Mr Y and Z can get together and out-vote him.
In company, B, by contrast, they raise the same cash by debt financing. Control does not change (but the company owes a debt).
Again, your ignoring the value of the share before its sold. The companies assets aren’t just the cash it has on hand, it also includes the cash value of the share. Selling the share should have no effect on the assets of the company.
It’s definitely going to be important to learn about how the interests of a shareholder might be different from the interests of a company. It’s even possible for shareholders to bring a lawsuit against the company, arguing that the company didn’t act in the best interests of the shareholders. This is kind of a big and general legal topic, so I’m not going to go into detail here.
In the current situation, using some of the numbers tossed around, using numbers rounded off to the millions, we have:
15m shares, $165m total market capitalization. But you need to understand right here that market cap does not equal actual value on hand. In fact, the company might even have a negative net worth (it has more debts than assets). The market cap just represents the market value of stock. But for argument, let’s say that the company has $50m of assets on hand, about $3.33 per share. (The remaining $8.67 per share would then be based on the shareholders’ expectation of future earnings, which the shareholders will earn via their dividend/voting rights.)
So the company issues 2m shares at the current price of $11 each, for 17m shares and market cap of $187m. The market price has not changed.
Right after the SPO, the company now has $72m of assets on hand. That’s $4.24 per share. So it’s actually gone up for the moment.
Of course, dilution has already struck; existing shareholders have about 11% less voting power and 11% less rights to dividends as before.
But… the company raised the money to do something with it, right? So it spends $20m.
Market cap might not change - maybe stock is still $11/share, total of $187m.
But the company’s net assets are now only $52m. So each shareholder’s share of assets is only $3.06 per share.
So, at this intermediate phase - the point at which you wonder why the stock has gone down - what’s been lost? Well, you lost 11% of $8.67/share (loss of future earnings via dilution) or about $0.79/share, and you lose $0.25/share in actual asset value. That’s a total loss of $1.04 per share.
Compare that to debt financing for the $20m. Net assets have still gone down ($0.50/share, so assets went down even more), but there’s $0.00 dilution of expected earnings. So shareholders lose $0.50 of value instead of $1.04.
But what about the increase profits? Well… if you’re a shareholder in the SPO, you get 89% of the increase thanks to dilution. In the debt-financed scenario, the shareholder gets 100% of the increase.
I appear to be missing something. Here is wiki on Stock Dilution. It is somewhat confusing as there is a lot of terminology I am having to parse, and the formulas described are in jargon.
In other words, you take the current [del]assets[/del] company value ($165M) and divide it by the total new number of shares (17M, not the original 15M) to determine the new shareholder equity, i.e. the value of each share.
So the original $165M in assets is now divided among 17M shares instead of 15M shares, dropping the per share value, and thus the per share cost.
Once people start buying in, the total assets increases, and the per share value goes up, so the per share cost goes back up.
But you’re not splitting $28 into 6 piles. You’re splitting $28 plus whatever he pays. That’s the point that everyone who says it is “dilutive” seems to miss.