Dilution is a term that many investors are familiar with, but it is often misunderstood. Simply put, dilution is a reduction in the value of an investor’s stake in a security resulting from a change in the investment’s capital structure. This change can be the result of an increase in the number of outstanding shares, or a decrease in their price, or both. When any of these occur, the percentage ownership of all existing shareholders is diluted.

Dilution usually occurs when a company issues new shares or additional debt as a form of financing. This instrument allows the firm to raise funds without borrowing from a bank, and the additional capital is then used for various purposes such as expanding operations, repaying debt, increasing working capital, or buying back existing shares.

The impact of Dilution on existing shareholders depends on the type of dilation. If a company issues a new series of shares at a discounted rate, existing shareholders may benefit by participating in the offering. On the other hand, if the company issues shares in exchange for new debt at higher than market rate, or a larger number of shares are issued to existing shareholders than they are entitled to, then existing shareholders are likely to be diluted.

One of the main ill effects of dilution is a decrease in earnings per share (EPS). EPS is calculated by dividing a company’s net income by the number of outstanding shares. Thus, if the number of outstanding shares increases due to dilution, the denominator of the equation increases as well, resulting in a lower EPS.

Dilution can have a further impact on the market value of shares. If the market feels that the dilution was unnecessary, or the new shares were issued at too high of a premium, the company’s share price may suffer. Thus, it is important for a company to ensure that the dilution is done in a way that benefits all existing shareholders.

To protect existing shareholders, boards of directors generally require that they approve any dilution before it happens. Companies must also disclose any dilution plans in their SEC filings. Dilution can also be deterred in more tangible ways, such as through the use of employee stock options and other equity incentives, or through the repurchase of existing shares.

In summary, dilution is a process that can be an important source of growth for a company, but it should be done in a carefully calculated and structured manner that results in a benefit to all existing shareholders, not just a select few. If done correctly, dilution can be a great way to raise capital and grow the company, resulting in an increased market value for shareholders and a higher EPS.