Companies issue equity all the time. It is considered a normal part of business. In fact, when equity markets are doing well, CEOs will often push for a rights issue, arguing that the market is over priced and therefore it makes sense to issue new shares and sell them into the market.

That might seem to make sense at first blush. But if a CEO thinks that this makes commercial sense then they are being naive. The only other explanation is that they are less than honest. Let us explore why.

As a first step, why is selling something at a higher than value price incorrect? In general, if it is a non-producing asset, then there is nothing wrong with this. Selling someone a pair of shoes should not cause any issues. The problem lies in what if it is a producing asset?

Consider the sale of a second hand car, as an example a Toyota Prado. If the market for second hand Prados is AED 50,000 and it is sold to someone who simply wishes to use it for personal use, then this is a commercially sensible trade.

But what if the buyer is looking to rent out the Prado, at say AED 5,000 per month? In that case the buyer has a commercial benefit far beyond simply the use of the Prado. They will make a lot of money. It might make commercial sense to negotiate in selling to them.

Moving up to the next analogy, consider the owner of a residential building who we will call Khaled. Khaled wants to buy a Ferrari for his personal use from Saleh. Khaled, noticing that the current real estate market is over heated, decides to swap an apartment in his building, at the inflated prices, for the Ferrari.

Khaled, and misguided CEOs, might believe that he has benefitted by trading one asset at an over inflated price (the apartment) for another asset (the Ferrari). The problem is that the apartment is a producing asset, it generates rent, and the Ferrari generates zero economic value. Actually, if you consider insurance, maintenance and extra petrol consumption, the economic value is negative.

As Khaled continues to market and improve his building, he generates continuing revenue improvements for Saleh without any effort or compensation on the part of Saleh. Khaled has sold himself into serfdom.

This brings us to the scenario of a company issuing shares because the CEO deems the current market price of the share as being expensive and thereby assuming that issuing shares at the current inflated market price makes sense.

The basic mistake that such a CEO is making is misunderstanding the cost of equity. Equity has a massive cost and not just because of the return on equity that shareholders might demand, although that is important. With developed market equity premiums to government debt benchmarks averaging, depending on which economist you ask, about 6 percentage points this implies a 12 to 15 percentage point emerging market equity premium.

The main cost of equity issuance, though, is dilution of equity shareholder return. To understand this point, let us return to Khaled, the building owner hankering for a Ferrari. Consider the scenario whereby Khaled, instead of trading away one of his apartments for the Ferrari, chooses instead to pledge the apartment to a bank in return for a loan that he uses to buy the Ferrari.

In this case, Khaled forfeits the economic benefit of the apartment for as long as the rent is needed to pay off the loan. But once the loan is paid off the economic benefit of the apartment reverts to Khaled. Contrast that with irrevocably surrendering the economic benefit to Saleh. It does not seem like such a great idea now, does it?

Back to the company scenario. What other options does the company have to raise cash? It could issue debt instead of equity. Or it could borrow directly from the banks. Certainly if the economic environment is so positive that the equity markets are positive then bank sentiment should be positive as well. Or it could simply wait and collect cash rather than give away equity.

Companies that are too quick to issue equity are usually driven by CEOs focussed on aggrandizement and boards asleep at the wheel. Their shares usually crash soon after. Shareholders are better served by longer term thinking boards and management who focus on retaining and growing shareholder value rather than diluting it.

This article was originally published in The National.