Investment Valuation Lessons I: Equity Dilution

Valuation techniques and methodologies are usually taught within the context of developing a financial model or using comparative ratios. In real life the actual decision makers might use the output of these models but will not be the ones who develop the models. Decision makers will also be influenced by other factors, not all of which are rational.

I have seen many examples of this and there are certain repeating patterns that are worth examining. In this post I will concentrate on how equity dilution leads to misperceptions and mistakes.

Value Destruction

Dilution has become something feared and avoided. I first saw this in the aftermath of the Internet bubble in 2000. So called investors, more accurately described as gamblers, piled into the market at extremely high valuations. When the markets crashed and the investee companies needed to raise more capital it was at a much lower share price.

The early investors were unhappy that their original shareholdings was diluted. When share prices dropped 70% the shareholdings in the companies and value of the portfolios of the early investors dropped similarly.

The problem here is that the dilution is not causing the destruction in value. The market crashed, the price dropped and the value of the shareholdings evaporated. In fact the capital raising leading to the dilution quite possibly helped increase valuations as it improved the balance sheet liquidity of the company at a time of financial distress.

Loss of Shareholder Voting Influence

The second issue that is misunderstood has to do with the voting power dilution. This especially applies to large shareholders who might own 10% or more of a company. Decision makers at these shareholders will naïvely overweight the importance of the value of a large voting bloc.

The first problem with this is assuming that the large shareholder who invested early and had a larger influence on the business that ended up in trouble due to over investing and spending pre the crash would somehow be better at influencing the business post the crash.

The other problem with this faulty thinking is best explained using a story taught to children: a small piece of a big pie is better than a big piece of a small pie.

Cash has Value

Probably the most puzzling distortion of rational valuation during a capital increase is the misunderstanding that cash has no value.

The faulty reasoning usually goes like this: the company has some valuable business or assets and these are of great value, so increasing the capital will dilute the value of the original shareholders shareholdings.

Now, understanding what the cash is going to be used for is essential and should have been done prior to the decision to issue equity. There are two main reasons to raise cash. The first is to invest in new projects. If these new projects have an expected IRR higher than the current business then new equity should be issued at a price lower than the current share price.

The other main reason to raise cash is to protect the value of the current business, i.e. there is a major liquidity issue and there are no cheaper sources of funding. In such situations what the decision makers of the original shareholders miss completely is that the value of the company is about to deteriorate quickly.

In such situations the shareholders need to understand that they are in a weak position with a deteriorating asset and time running against them.


Financial modelling is extremely important to the valuation process as well as the investment process. However cognitive biases can completely destroy the value of financial modelling. Therefore it is important to be aware of the types of cognitive biases that could come into play and to be vigilant that they do not improperly distort the valuation process.

This post is part of a series:

  1. Investment Valuation Lessons I: Equity Dilution
  2. Investment Valuation Lessons II: Value Attribution (Goes live Monday, 27 April 2015)
  3. Investment Valuation Lessons III: Discounted Cash Flows versus Peer Group Comparison (Goes live Wednesday, 29 April 2015)