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The Importance of Monitoring Dilution

|Includes:AAPL, AMZN, DryShips Inc. (DRYS), VLNCQ, WMT, XOM

   Two of the most under-followed metrics in today's world of data driven stock analysis are market capitalization and historical shares outstanding data. Investors religiously look at historical price charts, price to earnings ratios and a host of other indicators and barometers, many of them increasingly sophisticated and complex. By ignoring market capitalization and especially shares outstanding, though, they are leaving a crucial element out of their valuation analysis that could leave them with wildly different results.
    This difference is caused by dilution. Many stocks, especially (but not exclusively) the small-cap start-up sort, turn to issuing new shares to raise working capital on an annual basis. For the companies, this is actually a great deal. They get additional capital without any stipulations, debt, or other strings attached... an improved balance sheet overnight! For investors, however, these financing activities can be devastating, since the new shares crowd out existing investors, lowering their ownership of the company and thus the share price. To help investors track this problem easily, I recently created a new website,, which makes the data easily and freely accessible to anyone. Using the site myself, I have discovered that the problem of dilution is more wide-reaching and pervasive that I could have possibly imagined.
   Perhaps one of the main reasons investors routinely ignore dilution is that, at the time of considering whether or not to buy or sell a stock the dilution has already occurred, and it truly does not affect them by being in the past. What is missing, however, is that rarely if ever to individual investors (or even, in some cases, institutional investors) consider future dilution in their corporate valuations. Take a run-of-the-mill start-up type small cap, for example, based loosely on companies such as Valence (VLNC), Hyperdynamics (NYSE:HDY) and many others like them (biotechs especially). On an annual basis, the share counts of this company increases by 25-30% (this is a generously small figure) and has for many years. As an investor, you think the company has a chance to growth at the same 20% growth rate it has in the past 5 years, yet it trades at a P/E ratio of less than 10. Ceteris paribus, should you buy it? As you have likely already picked up from the set-up, the answer is that it depends on what kind of dilution you assume. If the dilution stays the same, your shares will decline in value each year (real value, not necessarily share price given the fickleness of markets). If the company stops diluting, then it seems as though you have identified a slam dunk company. Tragically, many individual investors do not add this step to their analysis (after all, companies don't like to talk about dilution very much, as it works out very well for them), see a slam dunk and buy it, only to be disappointed when the discover that even though their company has doubled in size their investment is flat or down.                      
      Don't think that investing in proven, blue chip stocks will complete insulate you from these problems, though. Though few blue chips are as profligate in their share issuance as small caps, their growth rates are often lower, leaving the same potential issues in a rigorous valuation of any type. Many large companies, such as Microsoft (NASDAQ:MSFT), Exxon Mobil (NYSE:XOM) and Walmart (NYSE:WMT) are shareholder friendly, buying back shares regularly. Others, however, still issue new shares each year, often as employee compensation, even as they build hoards of cash. Some leading, successful tech companies, such as Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN) continue to dilute their shareholder for no reason, saving on compensation costs at the expense of the owners of their company despite their massive amounts of cash. Regardless of the direction, for each of these companies the result is that a traditional discounted cash-flow model that assumes that a company's share count will remain constant is likely to be flawed, undervaluing companies like XOM and MSFT and overvaluing companies like AAPL and AMZN.                                                                                                   
      Raising awareness of this problem is the reason we founded, because individual investors must be able to easily and quickly find out the historical dilution of the stocks they are invested in. With this functionality now available freely and easily, companies that dilute have no place to hide, and investors should use, to the best of their ability, an informed awareness of past dilution to discount their valuation models. If you don't know the history of your holdings with regards to this vital issue, my advice is to look them up, either on our site or elsewhere if you would prefer. It will make your models more rigorous and hopefully help make you a better all-around investor.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.