From
Common Stocks and Uncommon Profits:
Therefore, if investment is limited to outstanding situations, what really matters is whether the company's cash plus further borrowing ability is sufficient to take care of the capital needed to exploit the prospects of the next several years. If it is, and if the company is willing to borrow to the limit of prudence, the common stock investor need have no concern as to the more distant future. If the investor has properly appraised the situation, any equity financing that might be done some years ahead will be at prices so much higher than present levels that he need not be concerned. This is because the near-term financing will have produced enough increase in earnings, by the time still further financing is needed some years hence, to have brought the stock to a substantially higher price level.
If this borrowing power is not now sufficient, however, equity financing becomes necessary. In this case, the attractiveness of the investment depends on careful calculations as to how much the dilution resulting from the greater number of shares to be outstanding will cut into the benefits to the present common stockholder that will result from the increased earnings this financing makes possible. This equity dilution is just as mathematically calculable when the dilution occurs through the issuance of senior securities with conversion features as when it occurs through the issuance of straight common stock. This is because such conversion features are usually exercisable at some moderate level above the market price at the time of issuance—usually from 10 to 20 per cent. Since the investor should never be interested in small gains of 10 to 20 per cent, but rather in gains which over a period of years will be closer to ten or a hundred times this amount, the conversion price can usually be ignored and the dilution calculated upon the basis of complete conversion of the new senior issue. In other words, it is well to consider that all senior convertible issues have been converted and that all warrants, options, etc., have been exercised when calculating the real number of common shares outstanding.
If equity financing will be occurring within several years of the time of common stock purchase, and if this equity financing will leave common stockholders with only a small increase in subsequent per-share earnings, only one conclusion is justifiable. This is that the company has a management with sufficiently poor financial judgment to make the common stock undesirable for worthwhile investment.
