What are fully diluted shares?
Once we include all conversion sources, such as convertible bonds and employee stock options, the company will make its fully diluted shares available for trading on the open market. Fully diluted shares include issued and convertible shares. Using fully diluted shares in EPS computations increases the share basis and decreases the dollars received per share of ordinary stock.
Understanding Fully Diluted Shares
Full-diluted shares affect EPS, a standard statistic for firm value and profitability. To calculate EPS, divide net income minus preferred dividends by the weighted average of common shares outstanding (starting period balance + ending period balance) / 2.
Increasing earnings per common share makes a corporation more valuable, and its publicly traded share price may rise. As the number of outstanding shares rises, EPS falls.
Considering Fully Diluted Shares
Suppose ABC Corporation (ABC) earns $10 million in net profits and distributes $2 million in dividends to preferred shareholders. Common stockholders receive $8 million in net income. The firm’s EPS will be $8.00 per share if its weighted average common shares outstanding is 1 million. EPS without dilution is $8.00, or “basic” EPS.
Total dilution indicates all convertible securities have been converted, reducing earnings per share of common stock. Investors should analyze basic and fully diluted EPS to assess a company’s worth and profitability.
Fully Diluted Share Example
To convert securities into common stock, consider convertible bonds, convertible preferred shares, employee stock options, rights, and warrants.
Assume ABC gives employees 100,000 stock options for good performance. Bondholders can exchange their convertible bonds for 200,000 shares of common stock at the firm. ABC also converts convertible preferred stock into $200,000 common stock.
The complete dilution scenario involves issuing all 500,000 new common stock shares, resulting in 1.5 million outstanding shares. After applying $8 million in earnings to common shareholders, fully diluted EPS will be $5.33 per share, lower than $8.00 per share.
Conclusion
- Total dilution may not occur immediately but suggests a future share count based on business policy on conversions.
- We remove cash dividends given to preferred shareholders from net income, as EPS only pertains to common shareholders.
- Company conversion policies may change, affecting future fully diluted share estimates.
