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I am trying to understand the concept of dilution.

According to https://www.investopedia.com/terms/d/dilution.asp, dilution is

Dilution is a result of a reduction in the ownership percentage of a company, or shares of stock, due to the issuance of new equity shares by the company. Dilution can also occur when holders of stock options, such as company employees, or holders of other optionable securities exercise their options. When the number of shares outstanding increases, each existing stockholder owns a smaller, or diluted, percentage of the company, making each share less valuable.

Questions :

  1. Why dilution makes each share less valuable?
  2. How dilution can profit for short sellers? Suppose a stock less than $1 (e.g. TOPS - TOP SHIPS INC (NASDAQ)).
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Regarding your first question, here a simplified explanation:

Assume a company A, worth 100\$, split into 100 outstanding shares. You own 5% of this company and, therefore, 5 shares or 5\$ of the company value. Now A issues 100 new shares to someone. But this will not necessarily raise the value of A. So afterwards you own 5 shares of a company worth 100\$ but with 200 outstanding shares.

This is roundabout 2.5% instead of 5%. And obviously the share could not be priced @1\$ each like before but @0.5\$. The company action diluted your investment. And this should also answer your second question independently from a specific stock.

A last note, this example is quite simple and the real world is more complex re company actions, short selling and derivatives. But the above should outline the basic concept of dilution.

Edit: Saw your edit re a detailed answer so I will extend my answer a bit re question 2:

A short seller could profit from the above as he typically lends the shares from shareholders, sells these and then rebuys the share at the end of lending.

Now let‘s go back to company A. You own your 5 share worth 5\$. Now a business partner asks to lend your share giving you 1\$ fee. Considering an unchanged share price this would be 20% return at the end. Cool!

Subsequently, your business partner sells your shares and waits until the end of your lending contract. He gets 5\$ from the buyer. (We assume 0% interest rate - to stay focused). In the meantime the above explained company action with the dilution takes place.

At the end, the short seller buys back the 5 shares for 2.50\$ instead of 5\$ and give you back your 5 shares and the fee of 1\$. He got 5\$ from the buyer at the beginning of his trade. Paid 2.50\$ for covering the short position. Paid 1\$ fee to you. Overall a gain 1.50\$ for the short seller. This is why short seller could profit from dilution.

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  • $\begingroup$ Very clear answer. $\endgroup$ – Daneel Olivaw Mar 18 at 16:03

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