A:

When a corporation releases its financial information, there are a few different variations used when reporting total earnings. These variations are: total dollar amounts, earnings as a percent of total revenue, earnings per share (EPS) and diluted EPS. The last item, diluted EPS, means that earnings are reported on a hypothetical amount of outstanding shares, and is calculated by dividing the net income for a firm during a given reporting period by the total amount of shares outstanding plus all shares authorized for issuance. Examples of shares that can be authorized at a future date include those that result from call options and convertible bonds. This type of earnings analysis is very helpful when analyzing a firm's financial information and stock price.

The rationale behind such an analysis is to evaluate the effect that issuing all of the authorized stock at once would have on the company's underlying stock price. Because the number of shares outstanding increases, the value of all per-share figures reported will fall, and analyzing a firm on this basis would provide the investor with a better sense on the "true" value of a firm on a per-share basis.

For example, suppose that a company has 5 million shares outstanding with a share price of $35, a market cap of $175 million and a reported net income of $3 million. The board of directors has also authorized a new issuance of 1 million shares, plus another 500,000 shares in stock options. The current EPS is $0.60, and is represented in the current stock price of $35. On a fully-diluted basis, we would get an EPS figure of $0.46 ($3 million/6.5 million shares).

If all parties exercised their options and the firm issued all approved shares, the share price would fall because there would be an increase in the number of shares outstanding. Because the firm would not have immediately changed in value after the number of shares outstanding increased, the market cap would remain the same at $175 million, but the share price would fall to about $30 per share ($175 million/6.5 million shares).

It is useful to analyze a firm on a fully-diluted basis because it better represents the firm's financial strength, especially earnings. Although every individual may not exercise every option at the same time, it is useful to see what would happen if they did because this provides investors with a very conservative estimate of company earnings.

For more information, have a look at Getting The Real Earnings.

RELATED FAQS
  1. Why is a company's diluted EPS always lower than its simple EPS?

    Learn about diluted and basic earnings per share and why a company's diluted earnings per share is usually lower than its ... Read Answer >>
  2. What's the difference between basic shares and fully diluted shares?

    Find out more about basic outstanding shares, fully diluted shares, the difference between the calculation of shares and ... Read Answer >>
  3. What is the weighted average of outstanding shares? How is it calculated?

    The amount of shares outstanding in a company will often change due to a company issuing new shares, repurchasing and retiring ... Read Answer >>
  4. What is the difference between earnings per share (EPS) and diluted EPS?

    Learn about EPS and diluted EPS, what they measure, and the difference between the two. Read Answer >>
  5. Why should investors consider the fully diluted share amount?

    Learn about the importance of considering the fully diluted shares, how it could affect a stock's share price and how dilution ... Read Answer >>
  6. What does it signify about a company if there is a large difference between its EPS ...

    Learn more about basic earnings per share and diluted earnings per share, what the ratios measure and what a large discrepancy ... Read Answer >>
Related Articles
  1. Forex Education

    The Dangers Of Share Dilution

    Investors need to be aware of the existence of dilutive securities and how they can affect existing shareholders.
  2. Fundamental Analysis

    Calculating Basic Earnings Per Share

    Basics earnings per share measures the amount of net income earned per share of outstanding stock.
  3. Fundamental Analysis

    Assess Shareholder Wealth With EPS

    Find out if management is doing its job of creating profit for investors.
  4. Markets

    Investment Valuation Ratios: Per Share Data

    By Richard Loth (Contact | Biography)Before discussing valuation ratios, it's worthwhile to briefly review some concepts that are integral to the interpretation and calculation of the most commonly ...
  5. Professionals

    Dilution

    Dilution can drastically impact the value of your portfolio.
  6. Markets

    The 5 Types Of Earnings Per Share

    A look at the five varieties of EPS and what each represents can help an investor determine whether a company is a good value, or not.
  7. Insurance

    Everything Investors Need To Know About Earnings

    We go over the concepts behind the excitement over the most important figure in the stock market.
  8. Investing Basics

    What are Issued Shares?

    Issued shares are the amount of authorized stocks a company’s shareholders buy and own. The annual report shows the number of outstanding shares.
  9. Economics

    The 5 Types Of Earnings Per Share

    Understanding the many varieties of earnings per share will help investors make informed decisions.
  10. Bonds & Fixed Income

    ESOs: Accounting For Employee Stock Options

    By David Harper Relevance above ReliabilityWe will not revisit the heated debate over whether companies should "expense" employee stock options. However, we should establish two things. First, ...
RELATED TERMS
  1. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  2. Diluted Earnings Per Share - Diluted EPS

    Diluted Earnings Per Share (or Diluted EPS) is a performance ...
  3. Primary Earnings Per Share (EPS)

    One of two methods for categorizing shares outstanding. The other ...
  4. Outstanding Shares

    A company's stock currently held by all its shareholders, including ...
  5. Basic Earnings Per Share

    A rough measurement of the amount of a company's profit that ...
  6. Fully Diluted Shares

    The total number of shares that would be outstanding if all possible ...

You May Also Like

Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center