Beware This Hidden Destroyer of Value

Share buybacks, done at the right price, can be a shareholder's best friend. Each share that a company takes off the market increases the value of your share. However, buybacks have an evil twin: share dilution. And it can eat into your potential returns.

An example
If you've purchased 100 shares of a company that has 200 shares outstanding, you have a 50% stake in the company and its earnings. However, if the company issues 200 more shares, shares outstanding jumps to 400 and now you only own 25% of the company. You've just lost half of your previous claim on the company's earnings.

Why shares are issued
Companies issue new shares for a variety of reasons, including rewarding employees, raising cash to repay debt or invest in new projects, or to acquire another company. These are all legitimate, but be sure the company acts judiciously. If a company begins tossing shares to employees like candy at a parade, it doesn't bode well for shareholder value. Or if a company finds itself selling off more and more shares to keep itself afloat, the viability of the business may be suspect.

Growing or steady
Let's look at two groups of companies, one whose stocks have seen significant dilution, and one whose stocks haven't:


Star Scientific Shares Outstanding Chart by YCharts

The companies that increase shares outstanding usually are in a growth phase. For example, Dendreon (NAS: DNDN) , the maker of the prostate drug Provenge, pumped shares from 82 million in early 2007 to 147 million today. The biotech firm had several secondary offerings to raise cash for funding research, trials, new manufacturing facilities, IT systems, and hiring employees. These investments seem to have paid off, as the company passed FDA trials and appears to be on its way to profitability.

Another company issuing plenty of shares: Star Scientific (NAS: CIGX) . This alternative tobacco company's shares outstanding have ballooned from 79 million in early 2007 to the current 135 million. Star issues more shares so that it can simply survive as a company, spending the new cash to pay for expenses, and so far has little to show in return. The company hopes to turn the corner with its new tobacco-derived Anatabloc supplement, and the quarterly earnings coming March 13 will help paint the picture on how the supplement has been selling.

One final example of a company using shares to speed growth is Rentech (ASE: RTK) . The synthetic fuel producer increased shares outstanding from 165 million at the end of 2007 to today's 225 million. Shares were sold to help fund the development of Rentech's renewable synthetic fuel center in Rialto, as well as help in the acquisition of SilvaGas in 2009. Rentech took note of its creeping share count, and recently announced the authorization of up to $25 million in share buybacks.

On the other hand, well established companies don't find it necessary to do secondary offerings so often. For example, Sun Life Financial's (NYS: SLF) share count exemplifies a more stable company that isn't investing heavily in research or acquisitions. Over the past five years, shares have dipped and risen, but only between a low of 559 million to a high of 580 milllion. The financial services company recorded a $300 million loss this past year, but continued to give shareholders a hefty dividend (near a 7% yield).

And Intel's (NYS: INTC) shareholder-friendly management takes its cash and not only gives back dividends to shareholders, but also takes shares off the market. Since 2007, shares have fallen from 5.85 billion to 5.09 billion. That means if Intel's earnings sat stagnant, earnings per share still would have increased by over 10% simply by reducing shares outstanding.

Watch that share count
Not all dilution is bad -- if Dendreon hadn't issued more shares, the company may not have had the cash required to bring its drug to market. However, a company must use its new shares or cash from selling shares wisely. Otherwise, it's an easy way for companies to hide underlying issues. And no matter what, share dilution is a great gauge of how companies treat shareholders.

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At the time thisarticle was published Fool contributor Dan Newman owns 100% of his portfolio. He also holds no shares of the companies mentioned above. Follow him @TMFHelloNewman. The Motley Fool owns shares of Dendreon and Intel. Motley Fool newsletter services have recommended buying shares of Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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