What are “Diluted Shares”?
Fully diluted shares outstanding are the total number of shares a company would theoretically have, including basic shares outstanding, if all dilutive securities were exercised and converted into shares. Dilutive securities include options, warrants, convertible debt, and anything else that can be converted into shares.
Diluted shares are most commonly used to calculate a company’s earnings per share (EPS). For a financial analyst, it is important to have a solid understanding of the difference between basic and fully diluted shares and what it means for key metrics including EPS.
Key Learning Points
- Fully diluted shares include all potential dilution resulting from securities such as: convertibles, options, warrants and RSUs
- Securities have to be vested and in the money to be included in calculating the fully diluted shares
- Diluted shares increase the share basis and thereby reduce the earnings per share
- If-converted method and Treasury stock method are used to calculate the fully diluted shares
Calculating Fully Diluted Shares
Fully diluted shares are calculated as basic shares outstanding plus the potential additional shares resulting from in-the-money dilutive securities. There are broadly two methods to calculate the potential dilution and it depends upon the type of securities.
This method is used when there is no additional form of payment to the company and is generally applied to preferred stock and convertible debt. When a preferred stock or convertible debt is converted, it increases the number of common shares outstanding. In addition, the preferred dividends and interest payments are no longer required as they have been converted to common stock and are added back on a tax-effected basis.
As such, this conversion increases the numerator and the denominator for calculating the EPS. We include the dilutive securities only when the impact on the EPS is dilutive. For preferred stock, this is when the basic EPS is greater than the preferred dividend. For convertible debt, this is when the basic EPS is greater than the interest expense.
Let us understand it with an example. We are provided with the information below and need to calculate the basic and diluted EPS:
We start with calculating the basic EPS.
For the convertible debt, conversion price ($50) < share price ($60), hence it is dilutive. If converted, the $5,000 convertible debt will convert to 100 additional shares.
However, this assumption also requires adding back the tax-adjusted interest expense (as the debt will have been converted). This would increase both the numerator ($1,270) and the denominator (1,100) in the diluted EPS calculation.
As we can see below, the net effect is the reduction in the EPS.
Treasury Stock Method: This method is used when the company receives proceeds upon conversion to shares. It is assumed that the company will use the proceeds to buy back the shares, thereby limiting the net potential dilution. This method is applied to options and warrants. Warrants and options are dilutive when the share price is greater than the exercise or strike price. RSUs are dilutive when vested.
Let us understand it with another example. We are provided with some information and need to calculate the basic and diluted EPS:
Since the conversion price is greater than the current share price, the warrants are dilutive and we assume conversion. The warrant holder can pay $40 to receive one common share worth $60. This will result in warrant holders receiving 150 additional common shares for a payment of $6,000 ($40 x 150) to the company. We assume that the company will utilize the $6,000 proceeds to buy back 100 common shares at the current market price of $60, resulting in a net dilution of 50 shares.
In this case, there is no change in the numerator and an increase in the denominator, resulting in reduction in EPS.
A key point to note is that both these methods are used only for ‘in-the-money’ securities. In other words, conversion is assumed only when the securities are dilutive on conversion. For securities like options and RSUs, they also have to be vested to be considered for potential dilution.
Use of EPS
The most widespread application for diluted shares is in calculating the company’s earnings per share (EPS). It is a common metric used by investors to assess the relative value and profitability of a company with its peers.
EPS is also used in merger analysis where public companies analyze if a sizable acquisition will be potentially accretive or dilutive to their earnings. Acquisitions that are accretive to the earnings are likely to be considered favorably by the investors as it increases the earnings available per share.
Disclosure: This article was prepared by Saumil Bhansali, a Director with Oppenheimer & Co. Inc. His opinions do not necessarily reflect those of the firm. This article is not and is under no circumstances to be construed as an offer to sell or buy any securities. The material herein has been obtained from various sources believed to be reliable and is subject to change without notice. Oppenheimer & Co. Transacts Business on all Principal Exchanges and Member SIPC 4560017.1