• Capital raises and share dilution can be a negative but also a positive if leading to greater growth and profitability
  • Martin Currie Australia considers how a company funds long-term growth as important component of their management and quality ratings
  • PrimaryMarkets said investors should look at how much value will be added to a company through capital raise compared to no capital raise

So, a company you’re invested in has just announced it is undertaking a big capital raise. Perhaps it’s a resources company looking for funds to do further exploration, a biotech needing the big cash to get a trial underway or a fintech making a takeover play.

Every afternoon at Stockhead we cover off the full list of companies that have gone into a trading halt, which has to be done before a  company pursues a capital raise, in both our Last Orders and Closing Bell articles.

When a company issues additional shares it can reduce the value of existing investors’ shares and consequently their proportional ownership of the company. Basically, it’s reducing your slice of the pie.

It is called share dilution and experts agree investors do need to be aware of the consequences of a capital raise on their stock. But just how worried should you be about share dilution?  Stockhead asked three experts for their opinion of capital raises and share dilution.

Understanding EPS accretion

Martin Currie Australia portfolio manager Will Baylis told Stockhead it considers how a company funds its long-term growth as an important component of their management and quality ratings.

“If a company can grow from the cashflow generated by the business, this suggests the company can have very low levels of debt and no need to issue new equity to fund future growth,” he said.

“If, however, a company does choose to raise equity, for example to fund an acquisition, via the issuance of new shares, it needs to result in EPS accretion.”

Baylis said typically an accretive acquisition increases the acquiring company’s earnings per share (EPS) and tend to be favourable for a company’s market price, improving long-term total shareholder returns. But on the other hand…

“If the use of equity dilutes EPS, the share price may fall to reflect the dilution and diminish total shareholder returns,” he said.

All comes down to value

PrimaryMarkets CEO Marcus Ritchie said the secret to understanding potential share dilution downside of raising capital is a comparison between how much value will be added to the company by sensibly deploying the capital raised versus how much value will accrue to shareholders in the absence of raising capital.

He said as an example to illustrate the point Company A shares are valued at $100 and, assuming no capital raising, expects to grow its value organically by 20% to $120 in 12 months’ time.

However, Company A also believes that if it raises $20 of new capital at a 10% discount to its $100 share valuation – ie at $90 – it can invest that capital and potentially drive the company’s value up to $200 in 12 months’ time.

“Clearly in the Company A example raising capital, even given a potentially dilutive impact, is better for all shareholders than not raising capital,” Ritchie said.

“However, if that capital is wasted and the value drops to $80 then everyone is worse off.”

So, what does it all mean?

“Have faith in management’s ability to use capital wisely to create substantial value accretion,” Ritchie said.

“If they believe in the company’s growth story then shareholders should be willing to have their holdings diluted on the premise that the capital being raised is adequately put to greater growth and profitability.”

Ritchie said PrimaryMarkets provides a trading platform for investors to trade in private companies,  like a stock market.

He said it also facilitates private company capital raises which are usually attractively priced compared to the premiums attached to IPOs.

“By providing trading liquidity to investors, this helps private companies raise capital as it enables investors to trade their shares,” he said.

“Historically investors holding shares in private companies could only exit via a trade sale to another market player or via IPOs, both of which are uncertain and can take considerable time.”

Dilution essential when analysing stocks

DNR Capital investment analysts Chris Tynan told Stockhead dilution is an essential consideration when analysing stocks.

“There are many reasons for companies to issue new shares, and if investors can’t (or don’t) participate at their pro-rated level, they effectively own less of the business than before,” he said.

Tynan said there were several examples early in the Covid-19 pandemic where companies raised capital to shore-up balance sheets.

“Whilst prudent at the time, the way many capital raisings were structured saw shares often placed at a discount to mainly institutional shareholders, some who were not even current holders,” he said.

“This made the process easier and fantastically profitable for underwriting banks, but unless a share purchase plan (SPP) was undertaken, it left shareholders, retail especially, to suffer significant dilution.

“As shares rapidly recovered, dilution left these shareholders with smaller relative ownership of the company and therefore lower returns.”

So, while dilution can be a negative, it can also be positive based on the premise the capital leads to greater opportunities for the company and your underlying investment will raise in value.