What is 'Dilution'?
-'Dilution' is the issuance of additional shares to the 'outstanding share count'. While not such a bad sounding definition, the impact of dilution can ruin a shareholder's position in a stock. The additional shares effectively 'dilute' the value of all shares on the market. Think of it like a pizza. The pie represents the market valuation of the company, while the slices represent the individual shares of the company's stock. When the company sells new shares, the pie doesn't get bigger, the slices simply get smaller. The investor is left with smaller slices.. or.. cheaper shares. Or if you want to think back to our swimming pool vs. coffee cup model model, dilution is like making the cup/pool wider. The increased capacity causes the liquid level, or price, to drop.
The direct effect of selling new shares can often be far more damaging than the proportional increase in shares warrants. Selling shares on the open market drives down the price; supply is increased, while demand stays the same. Without care a company can send their stock into a dilutive spiral that is very damaging to shareholders.
The purpose of dilution is for the company to raise money, plain and simple. In the grand scheme, the purpose for a company to go public in the first place is to provide a means for raising capital. You must find companies that do so in a responsible manner, without hurting shareholders. Always keep this in mind when trading any stock, and you will fall victim to dilution far less often.
What is a 'Reverse Split'?
-A 'Reverse Split' (or R/S, RS) is a method by which a company reduces the number of shares on the market and increases the stock price proportionally. Reverse splits are done at a specific ratio: ie - 10 for 1, or 10:1. This ratio would mean that if a shareholder held 1000 shares at 1 cent, after the reverse split the shareholder would be left with 100 shares at 10 cents each. The value of the position does not change from the reverse split... at least not directly from it.
Companies usually do a reverse split to increase the price of the stock to more attractive levels, or to remain at a minimum price for a particular exchange. While not necessarily a bad thing, a R/S is a popular method that bad penny stock companies use to continue raising capital through dilution. 'Dilution', if done enough, will eventually leave a stock virtually worthless. The price may go as low as .0001 dollars, the minimum that stocks are tradable by common investors. At this point the company can no longer effectively raise capital by selling more shares.
By performing an R/S, the number of shares on the market decrease, and the price increases back to a "dilutable" level. The dilution starts again, and the cycle can continue over and over. Because of this, a black cloud is associated with the R/S. They normally result in a large selloff by remaining shareholders, causing the price to plummet, and the shareholder value to follow suit.
A reverse split is very rarely an opportunity for a safe investment, and certainly not a wise choice for a beginner in penny stocks. To protect yourself from purchasing the stock of a company with a history of abusive reverse splits, check out this iHub board and scan through the list.
Reverse Split Repeat Offenders Listing
What is a 'Dividend'?
-A 'Dividend' (divi, divy) is a form of compensation a shareholder is given for holding a stock. They can be given as cash or stock and are normally paid for by company earnings. Typically, stable companies that are beyond the growth phase issue dividends to give shareholders a reason to retain an otherwise unprofitable stock.
With penny stocks, dividends are often given in the form of extra shares. Each shareholder receives a number of shares determined by a percentage of their current share count. For example, with at 20% dividend, a shareholder with 1000 shares would be given 200 shares. While this seems like an incentive to hold the stock, it often comes back to bite the holders. With these "free" shares coming into investor's hands, some, if not many of them will be sold at market prices to "cash them in". With this reputation, dividends and their announcements can often lead to a selloff. With penny stocks, a stock based dividend is essentially a form of dilution that is used to entice shareholders to buy, or continue holding the stock.
Advanced: Some penny stock investors, however, believe dividends can serve another function. If the stock has a large short, or 'naked short' position, it is often rumored that issuing a dividend can force the shorts to cover their 'short sale'. The resulting buying can then create a rapidly rising stock price AKA a 'Short Squeeze'. While this may very well be true, the question that needs to be answered is whether or not a short position even exists. Traders are often seen on message boards screaming "Short, Short, burn the Shorts!" - While the company plays along with them by declaring a dividend, a 'NOBO list', or filing for a new symbol. The hype of the possible short squeeze creates rapid buying itself, possibly resulting in a run. If the short actually exists, one can see some of the fastest percent increases in share price, and very high volume. If there is no short, it will normally result in a quick pop followed by an even faster drop as the "orchestrators" and pumpers sell out. These situations may be profitable for seasoned penny stock traders, but they are not recommended for beginners.
Read More about Naked Shorting Here
What is a '504'?
-A '504' refers to rule 504 of Regulation D. Regulation D is an SEC regulation which provides exemptions for companies to sell securities without having to register them with the SEC. Rule 504, specifically entitles a company to sell up to $1,000,000 worth of shares within a 12 month period of time, without having to register said shares. Essentially, rule 504 is a method for a company to quickly raise money through selling shares. While it is not considered the worst form of dilution, such as toxic convertible debentures, it is still dilution in the end.
Normally the shares sold must be 'restricted', meaning that they cannot be sold for a period of time (usually a year). This prevents immediate dilution, but the company must perform at some point, if the 504 shares are going to be held longer by the original purchasers, or absorbed by new buyers on the open market. In some cases, the shares may not be restricted. Click the link below for a more technical explanation, and circumstances in which 504 shares can be sold as non-restricted.
What is a "Gagged" Transfer Agent?
-A 'Transfer Agent' is a company's means of managing shareholder records, issuing and canceling stock certificates, and processing investor mailings. Some companies can act as their own transfer agent, but most often, especially with penny stocks, the job is outsourced to companies specializing in the business. Transfer agents are normally the most accurate, and often the only way of finding the current O/S, A/S, and float for a penny stock. Some will require a fax with shareholder details to retrieve the information, others simply a phone call or email. This type of transparency is desirable among investors.
A "Gagged" transfer agent is one which has been instructed by the company they are working for to not release information, such as the share structure. This is usually NOT a good situation. There is no legitimate reason for a company to gag their TA. It is almost always done to hide dilution. Some TA's, however, have a policy against releasing share structure information. The reasoning behind this is to keep the thousands of penny stock traders from bogging down their business with requests for information. Unfortunately this forces the shareholder to contact the company for information. While this isn't as bad as a company specifically gagging their TA, it still isn't an ideal scenario. Whether the company sought out this TA because of this policy, or it was a coincidence, is up for debate.
Without knowing the current number of outstanding shares, an investor has no idea if shares are being sold by the company. Concurrently, without knowing the number of authorized shares, the number of shares that can possibly be sold is not known either. Companies that practice this scam will often issue press releases, or other investor communication containing excuses for having the TA gagged. Unknowing investors will buy these up, and continue holding shares, or even buying more. We do not recommend touching a stock with a gagged TA, unless you are experienced with penny stocks, and it is purely a short term momentum play.
What's Next?
-Next we will learn how to find the hottest penny stocks that you will have the best chances of profiting with!
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