Equity Dilution vs EPS Dilution

Generally, people take equity dilution and EPS dilution as the same; but these both are different terms; let’s understand both with an example.

Let’s say ‘A’ and ‘B’ started a bakery named ‘AB bakers’. They both contribute Rs 50 each. So now ‘AB bakers’ has 100 Rs. capital to run a bakery. They issue 100 shares and both have 50 shares each

So, the company’s shareholding pattern is,

ShareholderNumber of shares% Holding
A5050%
B5050%
Total100100%

Company is making 25 Rs profit every year 

That is the company’s return on capital is 25%

After 1 year, A and B need more 100 Rs capital to infuse in their bakery

But they have invested all of their wealth already

They come up with the solution                                              

They invite person ‘C’ to invest 100 Rs in the bakery in exchange for a part of the ownership of the bakery; ‘C’ agrees and invest 100 Rs in the bakery

 ‘Ab bakers’ issues another 100 shares to ‘C’                                                         

So now, the company’s shareholding pattern is,                                                     

  ShareholderNumber of shares% holding
A5025%
B5025%
C10050%
Total200100%

As we can see, due to the investment of ‘C’ in the company (bakery), the original promoter’s ‘A’ and ‘B’ get their percentage stakeholding lower in the company

Their number of shares stays as it was i.e. 50-50, but percentage ownership gets diluted and reaches to 25% from 50%

I.e. they can get only 25% of the profit amount, their decision-making ability also gets diluted as now ‘C’ has more power to make a decision.

It is called Equity Dilution

Now let’s say due to an infusion of capital, the bakery is now working more efficiently than earlier                       

I.e. it was earning 25 Rs on their 1st capital investment of 100 Rs              

And is earning 30 Rs on their another 100 Rs invested capital                             

So now, it is like

So now, the company is earning 55 Rs profit on their total capital                               

Let’s now see the company’s profit distribution

It looks amazing!

So now let’s compare earlier and newer profits of ‘A’ and ‘B’

Earlier
ShareholderProfits
A12.5
B12.5
Newer
ShareholderProfits
A13.75
B13.75

Now we can conclude, ‘A’ and ‘B’ played a profitable game by having diluted their ownership in the company

It is not EPS dilution; it is EPS accretion.

There is equity dilution, but not EPS dilution

Then what is EPS dilution?          

Let’s suppose profit from that incremental capital infusion can’t make the company efficient, i.e. it didn’t work for the company and can’t generate decent profit then profit numbers look like,

And profit distribution will look like

Let’s now compare the profit of ‘A’ and ‘B’

Earlier
ShareholderProfits
A12.5
B12.5
Newer
ShareholderProfits
A10.75
B10.75

So, after having their equity/ownership diluted, ‘A’ and ‘B’ also decreased their proportion of profit            

That means their earning in the company get diluted

It is called EPS Dilution

Hence, two ratios become so important when we look for equity dilution and EPS dilution, those are

  • ROIIC
    • it is the return on incremental invested capital; if the infusion of capital works for the company, i.e. if ROIIC is high, there may be equity dilution, but there will not be EPS delusion
    • ROIIC is such a amazing tool to identify the efficiency of company’s new CAPEX
  • P/E
    • If a company (bakery in our example) is able to sell their stock on high P/E, then again that will lead to only equity dilution, not EPS dilution

Published by Aakash and Meet

I am Aakash Raotole I am currently doing Bcom from Dr. Patel and Rb Patel commerce college I am currently studying at finnacle investment academy Recently done distance internship with windrose capital, Pune - for a period of 14 weeks I am Meet Bhatt Completed HSC in commerce Now studying finbridge program at finnacle investment academy and Bcom externals I had completed CFA institute's investment foundation course and distance internship with Windrose capital, Pune - for a period of 14 weeks

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