Often lost in the conversation among amateur investors is the purpose of issuing stocks (IPOs). In an IPO, companies sell equity and list shares on the public market. Learning why a corporation issues shares and the consequences such actions have is critical for any investor.

What is a share?

A share of stock in a corporation is merely a finance term for owning a portion of the company. Say a company issues 100 shares and an investor owns 5, then they own 5% of that company. So the motivation for the company to issue these shares is simple. They want to to raise money for future projects; to do so, the company sells a portion of ownership to the public. That’s why an investor should never forget; the value of 100% of a Company’s shares equal the market value for that company. This is commonly referred to as market cap.

Institutional investors spend a great deal of money determining what this “real” value is. This is accomplished with a Discounted Cash Flow, or DCF, model. And simple calculations for this are openly accessible for all publicly traded companies. Any investor can take advantage of these models; however, institutional investors have much more resources at their disposal. If a company is “undervalued”, then the market cap is less than the value of the company. Therefore, an investor should buy shares in that company with the expectation that the share price will increase.

What is an IPO?

An IPO, or Initial Public Offering, is the first time a company openly sells ownership shares to the public. However, this is not the only time a company may sell its own stock to raise additional capital. There are multiple private funding rounds for most companies before they ever reach an IPO.

During each of these fundraises, existing investors experience dilution. That’s because each new sale “dilutes” the value of each share of stock. If our example company with 100 shares issued 100 additional shares, then our investor would own 2.5% of the company. This is dilution.

Most people quickly react and think of dilution as bad. That’s because dilution reduces the value of each individual share. So new capital raised by the company can offset this reduction. Therefore, the company can spend this capital to grow and make itself more valuable. So dilution is not always negative. As a result, investors must assess if the company’s usage of that capital will help their value increase. If so, then dilution may actually accelerate your returns.

In case you missed it… Check out our recent post about the G20 and if global leaders (and investors) are chasing an elusive dream

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