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Submitted by bynhunt on October 15, 2005
Category: History Other
Words: 6038 | Pages: 25
Views: 280
Popularity Rank: 38,533
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As an investor, few things assure you'll go hungry like a board of directors cutting the pie into more and more pieces and handing them out. Excessive share dilution is precisely that.
Dilution
Dilution is such a critical issue, yet few investors seem to pay much attention to it. By owning a share of stock, you have an ownership stake in a company. The intrinsic value of that share is a function of only two things: the intrinsic value of the business and how many shares are outstanding. If the share count is rising, then the shares you own are losing value, all other things being equal.
Imagine for a moment that you own 100 shares of a business with 1,000 shares outstanding -- in other words, you are a 10% owner and are therefore entitled to 10% of any profit distributions, 10% of the proceeds if the business is sold, etc. Now, let's assume that management initiates a generous (to them) stock option program that increases the share count by 4% annually. In about 18 years, the share count will double to 2,000 and your stake in the business will have been cut in half. Even if the value of the business doubles over this period, you've done nothing but tread water. Management, of course, has done fabulously: While getting paid salaries and likely bonuses every year along the way, they now also own 50% of the company due to the options they've received (assuming they've held their shares).
To summarize, options cost nothing in terms of cash or reported earnings, generate cash and tax deductions when they are exercised, create incentives for employees to stay, enrich management, and boost growth rates, margins, returns on capital, earnings, and, in all likelihood, the multiple the stock market places on these earnings. Given this ludicrous accounting, I wonder why companies don't issue far more options. For example, why should options only be used as a form of compensation? Why not pay other expenses like rent and advertising with stock...
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