When a corporation releases 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.
Dilution in Action
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. (See also: Getting The Real Earnings.)