Page 208 - Finance for Non-Financial Managers

Siciliano11.qxd 2/8/2003 7:28 AM Page 189
Financing the Business
Preferred Stock—
Ownership with Perks ...
ownership in a corporation
that entitles the stockhold-
and Limitations Common stock Equity 189
ers to dividends and/or capital appre-
There’s a way for the
ciation and the right to vote. In the
investor to mitigate the
event of liquidation, common stock-
risk without losing entirely holders have rights to corporate
the potential for apprecia- assets only after bondholders, holders
tion. If a company needs of other debt, and preferred stock-
additional equity capital holders.
and wants to avoid diluting
the value of its common stock, the choice might be to issue a
separate class of shares, such as preferred stock. Preferred
stock typically carries a stated dividend rate, in
Good for the Company, Bad for Shareholders
Issuing stock to raise cash helps the company, but it can
hurt the shareholders.
Consider the example of Wonder Widget, our rapidly growing com-
pany. It is publicly owned now, under the understated symbol WOWI.
The company is profitable, earning $1 million in net income last year.
You own 1,000 shares, out of 500,000 outstanding. The company’s
earnings per share (EPS) were $2.00 ($1,000,000/500,000). The mar-
ket thinks WOWI’s shares are worth 20 times earnings (price/earnings
ratio), meaning the company is valued at $20 million.Your shares
would bring $40,000 (1,000 x $2 x 20) if you sold them today.
But the company is still growing, so the next year it sells some
more stock, in a “secondary” stock offering: it sells 100,000 shares at
$20 to raise $2 million in cash. WOWI is better off now, but how
about you?
You still have your 1,000 shares and the company earns $1,050,000
that year, a 5% increase over the prior year. But since there are now
600,000 shares outstanding, EPS is down to $1.75 ($1,050,000/600,000).
The market still thinks the company is worth 20 times earnings, so valu-
ation is up to $21 million (20 x $1,050,000).Your shares, however, are
now worth only $35,000 (1,000 x $1.75 x 20).
The company has more cash and is making more money.You did
nothing different—and lost $5,000 in market value. That, dear reader,
is dilution.