Dilution Makes Weaker Stocks And Drinks
March 3, 2009 by Tisa Silver
Filed under Finance
With the government’s increased stake in Citigroup (Ticker: C), and rumors of similar moves coming for Bank of America (Ticker: BAC), shareholder dilution has become quite a hot topic!
Photo by ralphunden, Courtesy of flickr
The government originally purchased preferred shares in both of these firms. The shares purchased by the government can be converted into common shares, if necessary.
This conversion brings about fears of shareholder dilution.
What is dilution? I have found that the examples which work best with my students involve food, drinks and sports. So, here’s my explanation of dilution:
Suppose you are out for a drink and you order a rum and Coke. According to idrink.com, the typical rum and Coke is a 7 ounce drink with 2 parts rum and 5 parts Coke.
You enjoy the drink and return to the bar for another. This time, the bartender offers you a 14 ounce drink for the same price.
You are thankful, excited and prepared to recommend this bartender to everyone! But not so fast…
The bartender makes you a super-sized drink by pouring the same 2 ounces of rum into the glass with 12 ounces of Coke.
What’s wrong with this drink? It is bigger so it should be better right? Wrong!
The glass is larger and the drink is larger, but the proportion of rum got smaller.The rum in your drink has gone from 2 out of 7 parts all the way down to 2 out of 14 parts. That’s a drop from 28.5 percent to 14.29 percent.
In other words, the rum has been diluted.
This is what happens to the stake of existing shareholders when additional shares of common stock are issued. You may own the same number of shares, but the proportion of your ownership stake will shrink.
This is why dilution makes weaker stocks and drinks!
