Anybody who’s ever divvied up a pizza understands that the more people at the table, the thinner the slices need to be to accommodate everyone. You don’t have to love pizza like I do to understand this principle. It’s the same with stocks. The more shares outstanding, the smaller the stake in the company each share represents.

But most investors don’t track the outstanding share count of the stocks they hold, and that can spell big trouble.

Between 2000 and 2004, the share count for JDS Uniphase (Nasdaq: JDSU) doubled from 90 million to 180 million. That’s the same as if the stock split 2-for-1. You know what happens to a stock’s price after a split — it gets cut in half. And well it should, your stake in the business gets cut down the middle.

JDS Uniphase wasn’t (and still isn’t) profitable, but to illustrate, let’s assume it maintained annual net income of $180 million. In that case, doubling the share base would cause earnings per share to slide from $2 to $1. If the market is only willing to pay a certain multiple per dollar of profits (say, 20 times earnings), then we can reasonably expect the share price to drop by half — you can’t escape the cold laws of math. The stock actually hemorrhaged more than 98% of its market cap during the years in question. 

Simply put, if each share represents a smaller ownership claim than it did before, then investors won’t pay quite as much for it — regardless of whether the business is worth $10 million or $10 billion. So putting new shares into circulation is a sure-fire way to erode the value of a stock.

There are several ways this happens. Maybe a company is lavishing its top executives with stock options that are later exercised. Or it could be the result of convertible bonds, preferred shares or warrants being exchanged for common shares. Or perhaps it was just a secondary stock offering to raise cash; we’ve seen plenty of those in the past year.

#-ad_banner-#Unfortunately for investors, you won’t see the dilution data publicized much. Companies are quick to tell you how much money they invested in repurchases, but rarely mention the other side of the picture.

For example, between June 2002 and June 2005, Microsoft (Nasdaq: MSFT) cheered itself for spending $18 billion to buy back 674 million shares. But at the end of the three years, there were just as many shares outstanding as the beginning. Why? Because the company issued 666 million new shares during the same period. In other words, it was repurchasing shares with one hand and doling them out with the other.

And then there are companies who treat their shares as a form of currency for acquisitions. Networking giant Cisco Systems (Nasdaq: CSCO) went on a major shopping spree in the “Dot.com” era, buying up dozens of smaller rivals. Instead of paying the old-fashioned way, the company simply handed out 1.7 billion new shares between 1996 and 2002. For the most part, little regard was given to valuation — easy to do when you’re spending somebody else’s money. In the end, CSCO shareholders paid the price when the value of those acquisitions was later written off one by one. Meanwhile, CSCO shares have been stuck in neutral since the tech crash.

But the most toxic are cash-strapped companies with no choice but to give equity stakes to bondholders or sell new stock on the open market just to keep the lights on and the doors open.

Whatever the cause, the issuance of new shares is dilutive to existing investors. With all this in mind, the companies in the table below have ballooning share counts — and disappointed investors.

By itself, an increase in the number of shares isn’t always a reason for panic. Sometimes there are extenuating circumstances — the entire financial sector has been forced to recapitalize in the wake of the subprime meltdown. And there are always growing businesses like Apple (Nasdaq: AAPL) that have issued plenty in recent years and still rewarded investors handsomely.

The key is to gauge how effectively a company is deploying the proceeds — returns on invested capital (ROI be a good start — it measures how well a company puts its capital to use. Those in the table above rank poorly by that measure and have other red flags that warrant caution.

YRC Worldwide, for example, just orchestrated a $537 million equity-for-debt swap to stay afloat. E*Trade just completed a secondary stock offering and has over $1 billion in convertible bonds that will soon be exchanged for common shares.
 
Action to Take –> If you own any of the stocks listed above, you might consider selling as your position has been heavily watered down… and that means the value of your holdings has eroded. All things equal, I prefer larger slices of stable companies loaded with meaty assets and cash flows instead of seeing those shares become worth less and less.