Back to the Basics: Stock Dilution and the Main Types of Investments Explained Simply

0:00So last week we talked about a lot of stuff. We talked about why a stock is even a stock on the stock market. We talked about IPOs. We talked about the financial statements. Well, this week we are going to talk about something that I don't even understand a whole lot. So I'm super excited to get Andrew's take. This week we're going to be talking about share dilution. This show is sponsored by Liquid IV. Now that the weather is finally heating up, one of my favorite ways to step away from spreadsheets and the SEC filings is getting outside for an early morning run. But once the summer heat truly kicks in and I start breaking a serious sweat, I know I need to hydrate and actually replenish.

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3:16with them your path to financial freedom start now welcome back to the investing for beginners podcast everybody my name is steven morris across the way is the guru himself uh we call him the mini warren around um no pressure um but anyway uh so oh where was i totally your uh-oh threw me off oh that's andrew sather um so yeah we're gonna be talking today about shared dilution and i honestly andrew i don't even know where to start like i understand like the basic concept of too much shared dilution is bad on the flip side not enough is also bad um but i really don't even know where to start the conversation like i don't know what questions to ask when it comes to trying to understand the nitty gritty of shared illusion.

4:14Yeah, it's a good tag along to what we talked about last week. So with our episode about IPO, so we can just piggyback on that and talk about dilution. It's a very interesting topic because becoming increasingly interesting because companies are finding more and more creative ways to create dilution, which is good for the company is not always good for us as shareholders. So we just need to be aware and equip ourselves so we can figure out when it's getting too egregious and just stay away from those situations when it's like that. So think about an IPO. Let's say Steven and I went to IPO our company and we owned 80 % of the company.

5:00And let's say we wanted to sell 30 % just to make a nice round number. so we would sell 30 of the company wall street would come in do their dog and pony show obviously they would bid us up because we have a hot company right like four times over subscribed i'm not accepting anything lower than that and we would uh so like if you if you just took that simple math of like we give away 30 we keep we had 80 now we F50. That's an example of dilution. We've essentially lowered our ownership stake in order to raise capital for the business and also potentially cash out a little bit too. So that's kind of the idea behind dilution.

5:47And usually it's a little more complicated than that. You go based on your percentage and if you dilute, let's say 20%, you're not subtracting 20 % from your ownership, you're doing it in proportion to your ownership stake. But, you know, we don't have to go there. But basically, that's the oversimplification of what's happening with dilution. So the way I've kind of always envisioned to tell me if this makes any sense to you at all is I love sweet tea, right? Like, and I make fire sweet tea. It's not, it's not too sweet because you southerners love to destroy sweet tea by dumping a pound of sugar in your sweet tea and that's too much if i want a coke i'll just go go get a coke like i want sweet tea so i want to be able to taste the tea not sugar anyway i digress um i make awesome sweet tea and the way i the way i look at it is you know i i make my perfect uh perfectly proportioned sweet tea in the morning and then later on in the day i have we'll say 10 guests show up rather than making a new batch of sweet tea i just add water to my current tea and so now my suddenly perfect proportioned sweet tea has now become diluted with water and it's not as uh amazing as it was i guess so and i guess that makes dilution sounds really bad um but like i said there there are times when dilution is really good for us as investors as well um can you talk about well one does my analogy make sense or is that like i like it i like it cool cool so here so here's where it goes right um the the amount of you're asking is the dilution bad when you're adding water so it depends on how much sugar are we getting from the water that's been added right right yeah so like if we're adding all water and the business makes no sugar from those investments then it's terrible because now we just have less sugar for everybody but if they're able to go out there and this is perfect because now we can turn your mid let's be honest your mid sweet tea and if we can make even more sugar than was originally in there that's when dilution was good because adding more water let the business you know make that much more sugar and now we have a sweeter tea got it love it and so when it comes to uh stock buybacks because that a lot of time that's where that real power for the company comes is when they start buying back um shares because they're basically getting rid of that dilution.

8:48And I don't have an analogy for that because you can't take away sugar or water from sweet tea. But I mean, there are times whenever buybacks are amazing and that's what we look for, right? We look for a stuff where they're giving you buybacks and dividends. but there are also times when buybacks are just absolutely a horrible horrible horrible place for the company to be um why why why is it bad and why are they doing it if it's bad if they're doing too much share buybacks yes yeah uh the analogy for share buybacks which we've used before. Say we have a pie of pizza. Each of us has a slice. That slice of the pie can represent your share of stock.

9:40And when a company does buybacks, your share is getting bigger, even though the size of the company is staying the same. So we're all getting bigger and bigger shares of the pizza. That's your ownership stake going higher and higher as the company is buying back shares and retiring them. Where that can be problematic is when they do this from a non-sustainable place where they are, let's say, borrowing a bunch of money, which you'd be surprised how often this happens. Borrowing to buy back. Okay, I understand that's a good benefit for us in the short term, but what about when we got to pay that debt back, right?

10:22So that could be a situation. or if a company is just like, we could invest to grow, but we're just going to buy back stock because Wall Street likes it when we do that. Again, you're sacrificing the long-term future to have short-term results. So that's when buybacks can get an ideal. And then the last big one, actually, which I almost forgot, which would be a bad thing, is when you buy back stock when the share price is so expensive. when uh like your priced earnings is a hundred or something the amount of shares they're able to buy back is so small that it's like you're kind of just putting money on fire and billions and billions of dollars are going to increase my ownership stake by 0.01 like come on give me a break you guys can do better things with that money so that happens a lot too and And those are just things we have to watch out for as good investors.

11:24I mean, it really seems like you're using a credit card to pay off another credit card. I mean, is that fair? Yeah, I mean, kind of. Yeah. Yeah. I mean, it's like I'm not the greatest. I mean, maybe that's a question for Evan, but I've never heard a success story of using debt to pay off other debt. I'm sure it happens I'm just not a big fan of it And then I think the ugliest form Which is Andrew's absolute favorite thing To see a company do Which is stock-based compensation Yeah,

12:04it's getting out of hand at this point They're handing out stock options Like lollipops And some of these companies Shouldn't be doing this So I understand that you have to invest in talent and some of the best talent, engineering talent, whoever, they expect stock options. So, yeah, you have more strong engineers. You get a company like NVIDIA. We can all see how that can be a great investment. But it's one of those things that can be manipulated and even more highly manipulated than some of the other ways. It's like you borrow$10 billion, people will see it. But if you're a company, I don't want to throw out any names, but there's like software companies out there who grow really, really fast.

12:58And they seem to have great numbers. And it's like, ooh, they're buying back$2 billion in stock. But if you look at their share count, their share count did not move because they're issuing so much stock as stock-based compensation. and stock-based compensation is one of those magical numbers where you can make everything look good except for your share count so you really have to look at the share count and share counts just not it's like one of those details that if you're not digging deep enough you probably won't know this because all the other numbers are going up so earnings per share might be going up so okay everything's good but if if in the background all the profits you're actually making are just going towards these buybacks then what you have is you have reported profits turning into money that just evaporates and that's yeah i mean it's been sustainable for so long but how sustainable will that be it all depends but i don't like to see it i mean a few episodes we were talking about a company i'll name names snowflake um we were talking about and was something like 1.9 billion they spent in buybacks or something along those lines and their share number went up still and it's exactly what you're saying you know they spent all that cash to buy back stock and their share uh account still went up yeah that's that's that's not a good it's not a good number to see well then what's the point of making money

14:41who needs it um so when you're researching a company um for for our newbies out there where can they find um something like the the share account or where where would they go to see that yeah it's usually in the income statement so you can look near the bottom of the income statement. Usually in the bottom, you have the bottom line, which is your net income or your profits. And then you have an earnings per share number. And then oftentimes they put the shares that they use to make that earnings per share calculation. So that's all right there. If you can't find it in the income statement, you can also control F in an annual report and you can find shares outstanding.

15:30They have to report how many they have. So you'll find it, but most of the time it's in the income statement and you can use a tool like fiscal.ai. They always have it in the same place. And that's also in the income statement. You would be looking for shares outstanding, wouldn't you? Yeah. Sorry. What did I say? I don't remember. Okay. Yeah. Shares outstanding. So there, there's two types of shares outstanding and there's basic and diluted. I always look at diluted because it, it assumes that whatever stock options they've given out like candy assumes that those will get exercised which is like duh like of course you want to account for those we don't just ignore we don't just ignore the stock options that are floating out there right that haven't been exercised yet so uh diluted shares outstanding and you can look at the income statement yep Got it.

16:24And so, I mean, is that say, we'll say, what's your favorite stock? We'll say Texas Roadhouse. Yeah, that's the one lately, right? They start going the route of Snowflake and just they're buying back tons of shares and but their share count's still going way up. is that uh i sell them instantly or is that i dig deeper to see what's going on try to figure out what's going on or you know they've been a solid business thus far they know what they're doing i'm going to trust them where where would you sit on the fence on that one i guess i'm a little bit of a control freak so if i don't like what you're doing I'm just going to be honest.

17:14If I don't like what you're doing, I'm probably out. So a good example of a company that did this would be Builders First Source. They had a huge merger they did. They merged with one of the biggest companies in their industry, them also being a huge company in their industry. And so their share is outstanding, like doubled or tripled in a single year. what's crazy about them is they bought back so much stock in the years to follow that they're now below where they were it might not have doubled don't quote me but like they diluted a ton but i think the acquisition made sense and you can check things like return on invested capital might be a good one to look at if that falls really low maybe they overpaid um or you can just look at like does this make common sense i'd probably do both like is this a common sense acquisition and did it did they pay a good price so is roic still okay so i think with field builders I think I bought after the big merger.

18:29But if I bought before, then that was definitely something that came to mind. But I'm definitely like, hold up. What's going on here? I'm clearing my schedule. I'm going to see what's going on. So it would worry me. But I think what you're saying, like having some trust and some faith in the companies that you have invested in, that probably is a good way to do it too. Like I said, I'm just, I'm a little weirdo. No, I don't think so. I mean, I think both sides have merit, you know, to bring it back to Warren Buffett. What was his biggest thing? Capital allocation, right? In order to have good capital allocation, what do you have to have?

19:11You have to have good management. If you don't have good, you know, maybe they've had great management up until this point. and then someone retires, quits, moves on, now all of a sudden that management's gone, that could be something to pay serious attention to. Because, you know, if they're breaking that number one Buffett rule of capital allocation is king, then, I mean, I can't picture a scenario where I would be okay with it. say Texas Roadhouse acquired Chick-fil-A. Oh, no. Using stock. No? No, no, no, no. What? No, no, no, no, no. Okay. No, no. No, we don't. Would you be okay with that?

20:10Because it's Chick-fil-A, probably. I don't know. uh that now you literally just dumped a bucket of cold water on me and i i had a point that i was getting to and now i don't even i don't even remember what it was because all i can think about is texas roadhouse buying chick-fil-a um i mean that would be that would be a good acquisition for them though because they you got texas roadhouse then you got bubba's burgers which i've never had like have you been there is it is it good yeah i still have my ticket you can't see it but i put my ticket up on my bookcase that's why bubba's 44 or something 33 33 okay yeah i was 11 off so anyway but they don't have one um next to my art texas roadhouse it's further down the road um but there there is one i've just never been to it that they would pretty much have the entire market corner they would have your your steak your burger and your chicken um i'm a big fan of chick-fil-a if you haven't figured that out by now i think we all are you know what takes me off dude like i totally respect the fact that they're closed on sunday um yeah

21:32religious stuff is like not bringing that anywhere into the conversation i think that it's awesome that they've stuck to their guns they're like this is how we operate yeah and we're going to continue to operate that way no matter what and no one has been able to bully of them not even the nfl because yeah the they put um a chick-fil-a i think it was the atlanta it's not to suit what's the atlanta stadium i can't remember the whatever stadiums in atlanta for the falcons they put a chick-fil-a in there and sun football's on sunday most of the time and so it's never open for the football games and the nfl tried to tell chick-fil-a like you're going to be open they're like no we're not that's awesome and even here in indianapolis when they put chick-fil-a in the airport they tried to the city tried to bully chick-fil-a into being open on sundays and chick-fil-a is like no um and i i just love that i love that they they have their principles whatever they are and they stick to them that and that gives me a lot of faith in a company when I know they even some of the most powerful entities in the world I mean the NFL hands down is one of the most I don't know I would say they're one of the most powerful entertainment companies at least in the world yeah yeah and you know Chick-fil-a doesn't doesn't even bat an eyelash and telling them no I just I think that's so cool but anyway I say all that to say the only time I want Chick-fil-A is on a freaking Sunday.

23:17It never fails. My wife and I will be out grocery shopping like, you hungry? Yeah, let's go get some. Okay. What do you want? Chick-fil-A? Oh, this sounds great. And we get halfway there and it's like, crap, it's Sunday. Anyway, what was I talking about? I don't know, but now I'm hungry. Jay, what is today? Thursday? Chick-fil-A is open. It is. This is true. But anyway, so I mean, that makes a lot of sense. Thank you for breaking it down. It's so easy to hear a shared dilution and instantly think it's something bad because when you dilute, typically it's bad. You don't want your sweet tea diluted.

24:03You don't want your motor oil and your engine diluted. But the way you broke it down makes a whole lot of sense. Oh, I remember. I was talking about Warren Buffett's capital allocation rule. When it comes to a beginner looking at the share dilutions, is there a key number percentage-wise they should be looking for when it comes to allocating towards buybacks versus other types of investing? Does that question make sense? I've been paying a lot more attention to how my body actually performs and recovers lately, especially since I've been having a huge focus on building muscles in the gym, not just for the aesthetics of it, but for the long-term mobility benefits of it.

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27:17For a limited time, you can access this research at a discount at einvestingforbeginners.com slash reignite that's e investing for beginners.com reignite i think so so you're asking like as an investor like me as the stock picker yeah as the beginner what what should you be looking for when it comes to share dilution like is there a set number yeah for sure um i would look at the trend of your of the actual shares outstanding so go back to that metric that we highlighted in the income statement. Your share is outstanding. Diluted share is outstanding. What's the trend? Is it going up? Is it going down?

28:00And again, to shout out Fiscal again, they have a feature where you can just click on whatever metric you want to click on. So you can click on diluted share is outstanding. And it displays right there 10 years, which by the way, before tools like this, I had to go like input in my Excel spreadsheet. And this wasn't too long ago, by the way. So these are really awesome time savers. And you can use the fiscal slider to tell you how much it is on a yearly annual basis. So they have a little CAGR number and this shows, okay, cool. This company is reduced share count by 2 % annually. And that's how I would do it.

28:43I would stay away from... This is maybe a little strict. a little bit of like angry teacher wrapping their yardstick at your desk, I would stay away from companies that are diluting unless you really deeply understand what they're doing and deeply understand their business. Just if you look at, I can't remember if it was Mobison, but somebody looked at what is the performance of different stocks and the ones that dilute can be put in a different life cycle bucket. And those have greater chance of underperforming. So the ones who do outperform tend to outperform by a greater amount, but more of them underperform.

29:35So I would be very careful understanding that a lot of dilution does make your sweet tea less sweet. And that's just kind of how it goes. But the ones that do it well, those are the ones like the Teslas of the world, the Amazons of the world. Like those guys have figured it out. And the investors who had it in their gut, like they knew that this was the right thing to do with the dilution. Yeah, they've made off pretty well. Made off very, especially with Tesla. Yeah, very well. No, that's brilliant. So we got a little bit of time left, Andrew. Let's shift gears a little bit into different types of stocks or different types of investments.

30:25Because, I mean, we've had comments before. I think I brought it up recently about, you know, why don't we ever talk about gold? It's such a great investment, blah, blah, blah. And my answer was simple. That's just not what we do. talk a little bit about the different types of investments that are out there and what makes them unique, I guess. Okay. So let's start with gold since you brought that one up. Gold has long been looked at as a store of value and for good reason. you go back in history gold was one of the few things that you could really count on and people traded with gold and in history if you're really like a nerd and i know steven you're probably way more than i on this but maybe you can back me up like traditionally when civilizations diluted the amount of gold in their currency it did not end well for those is that generally yeah Yeah.

31:36Massive inflation. Yeah. So we did that. Raise our hands, USA. So we'll see how that goes.

31:48But yeah, so just it has this this historic precedence. I don't think anything else in the financial industry today has like gold has been around. You know, since since Jesus Christ. Yeah. So people people trust. that track record. That said, just because something's a store of value doesn't mean it creates value. So what I like about stocks is, as you can tell, if you've listened to any episode of our podcast, stocks are businesses and businesses create profits. Ideally, they try to. And so that's value that's created. And as a business creates value, it tends to grow and it can get bigger and bigger and your investment grows.

32:33You buy a rock of gold. It's still a rock of gold like two years later. Yes, the price goes up or down as a store value, but that gold doesn't generate anything. And so that's been my big reason I don't have any gold is just because I prefer... Like there's no cash flows that gold... produces whether itself or through other means so um yeah that's why i don't invest so i i know like gold is marketed now and i'm not don't get me wrong i'm not trying to crap on gold but gold is marketed now as a safe hedge against the market basically like you said it's going to retain its value in the and i don't know the answer to this i'm and i don't know if you do either in the great depression back in the in the 20s and 30s you know the people that owned gold how i mean the depression hit them just the same did it not because nobody could buy gold right so or am i thinking about that completely wrong um i think when we say hedge it depends like so like for me or you right like we have 20 year plus track record or not track records 20 year plus time horizons for our wealth building journey so we can survive even like a great depression if we had a great depression for the next 10 years the optimism in us would say hey we'll come out of it and another 10 years we'll have recovered so we don't feel a need to hedge but maybe somebody close to retirement feels that need to hedge and needs that psychologically and so in that case like i understand the hedge but i guess i always come from rightly or wrongly sometimes i forget like not everybody's me but like i come from this viewpoint of like i have a long time horizon so whatever happens is okay because i'm gonna ride it out and so i don't need a hedge but yeah maybe somebody does i mean i just i've always wondered because in my mind that's you know the great depression happens what's valuable food is valuable yeah um ammo you know ammo yeah you know zombie apocalypse definitely ammo most valuable assets you can own so moving on uh what would be the next investment you think is important to understand

35:30Well, I guess since we're along that topic, we can talk Bitcoin because it's kind of hard to ignore Bitcoin at this point and other cryptocurrencies. Bitcoin, last I checked, I think it's somewhere between one to two trillion. So it's a pretty big asset class at this point.

35:53Have you seen that meme of the dude that like paid for a pizza with a Bitcoin because he didn't have the cash? It was like at the very beginning. He probably wishes he never heard of Bitcoin in his entire life. I don't know if it's true. It was a meme I saw. I think it is. No, I think it's totally. Yeah. he's like he's like digging through garbage dumpsters to try to find his bitcoin wallet like that's gotta be painful man that's gotta that's gotta hurt i'm sorry i mean yeah anyway seriously yeah um bitcoin's been like one of the craziest probably the craziest financial instrument of all time.

36:40Like it's been around 17 ish years and it has, um, um, just risen the fastest, I guess, you know, like we always see those charts. Technology has empowered chat GPT to grow the fastest of any technology we've ever seen. Well, same with Bitcoin as a financial instrument. There's a lot of people, um, and I have long been one of those who are just like so negative against Bitcoin because all the arguments you can make for gold, you can also make for Bitcoin. Like does Bitcoin provide, like does it generate value? And I don't know, the more I've gotten to learn about it, the more I think Bitcoin's more like a guardian of the internet, which we don't have time to like get into today.