What are 'Fully Diluted Shares'
Fully diluted shares are the total number of shares that would be outstanding if all possible sources of conversion, such as convertible bonds and stock options, are exercised. This number of shares is important for a company’s earnings per share (EPS) calculation, because using fully diluted shares increases the number of shares used in the EPS calculation and reduces the dollars earned per share of common stock.
BREAKING DOWN 'Fully Diluted Shares'EPS is a calculation of the dollar amount of earnings a firm generates per share of common stock outstanding, and analysts consider this ratio to be a key indicator of company value.
How Earnings Per Share Is Calculated
EPS is defined as (net income – preferred dividends) / (weighted average common shares outstanding). Any earnings paid to preferred shareholders as a cash dividend are subtracted from net income, because the ratio applies only to common shareholders. Weighted average common shares is the (beginning period balance + ending period balance) / 2. If a business can generate more earnings per common share, the company is considered to be more valuable and the share price may increase.
Assume, for example, that ABC Corporation generates $10 million in net income and pays all preferred shareholders a total of $2 million in dividends, so that the net income available to all common shareholders is $8 million. If the firm’s weighted average common shares outstanding total 1 million, the EPS is $8 per share. The $8 EPS is considered basic EPS, because the total is not adjusted for dilution.
Factoring in Fully Diluted Shares
Full dilution means that every security that can be converted into common shares is converted, which means that there are fewer earnings available per share of common stock. Since EPS is a key measure of a company’s value, it’s important for an investor to review EPS. Several types of securities are converted into common stock, including a convertible bond, convertible preferred stock, stock options, rights and warrants.
As an example, assume that ABC issues 100,000 shares in stock options to company executives to reward them for reaching a profit goal. The firm also has a convertible bond outstanding that allows the bondholders to convert into a total of 200,000 shares of common stock, and ABC has convertible preferred stock outstanding, and those shares can be converted into 200,000 shares of common stock. Full dilution assumes that all of the 500,000 in additional common stock shares are issued, which increases the common shares outstanding to 1.5 million. Using the same $8 million in earnings to common shareholders, fully diluted EPS is ($8 million / 1.5 million shares), or $5.33 per share, which is lower than the basic EPS of $8 per share.