Dilution Adjustments

Stocks have to be adjusted for the dilution effect of stock splits, consolidations, spinoffs, capital returns (special dividends), rights issues, and reconstructions. The purpose of a dilution adjustment is to remove the price gap after a diluting corporate action (e.g. a stock split) and to provide a price history consistent with the current number of shares in issue. Data from brokers or the Internet is not normally adjusted for dilutions. Without adjustment, indicators signals are distorted — and can lead to incorrect trading decisions.

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Share Splits

Share splits are the easiest to understand. In a 2:1 share split the number of shares is doubled, by issuing extra shares to existing shareholders for no consideration. 

The dilution factor will be 0.5 as there are now two shares in place of one.

Special Dividends: Return of Capital

Not to be confused with normal dividends paid out of current operating profits, special dividends normally occur when a company sells a major asset or subsidiary. If the company has cash surplus to its requirements, the directors may distribute the surplus to shareholders by way of a special dividend.

Example

If you are the only shareholder in a company with 1000 shares, worth $10.00 each, and the company pays a special dividend of $2.00 per share from the proceeds of sale of a subsidiary:

The new value per share is therefore  $8,000/1,000  =  $8.00

The dilution factor is therefore  $8.00/$10.00  =  0.80

If the chart is not adjusted, it will show a gap of $2.00 between the closing price and the opening price on the next day.

Spin-offs and Reconstructions

Companies sometimes spin-off a subsidiary by issuing shares (in subsidiary) to their shareholders for no consideration. Reconstructions cover a whole spectrum of arrangements that may affect the market value of issued shares. They are more complicated, but the same basic principles apply.

Rights Issues

Rights issues are where a company issues additional shares to existing shareholders, normally at a discount to the current market price.

Example

If you are the only shareholder in a company with 1000 shares, worth $10.00 each, and the company issues an extra 200 shares to you (a rights issue) at $7.00 each, the new value of each share can then be calculated:

The new value per share is therefore  $11400/1200  =  $9.50

The dilution factor is therefore  $9.50/$10.00  =  0.95

If the chart is not adjusted for dilutions, it will show a gap of 50 cents between the closing price and the opening price on the next day.

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