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,
|Shareholder||Number of shares||% Holding|
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,
|Shareholder||Number of shares||% holding|
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’
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’
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
- 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
- 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