Investors should consider a company's fully diluted share amount before purchasing the company's stock, because it could cause a company's share price and earnings per share figures to drastically plummet if convertible security holders decide to exercise their securities.

Understanding Fully Diluted Shares

Fully diluted shares, unlike outstanding shares, is the total number of shares that would be outstanding if all convertible securities, such as options, warrants, convertible bonds and convertible preferred shares, were exercised.

If a large number of convertible security holders decide to claim their common shares, it could cause a significant plummet in share prices.

For example, assume Company ABC currently has 50 million shares outstanding, 250,000 equity options, 250,000 warrants and is currently trading at $10 per share. Each equity option and warrant could be converted to 100 common shares. If all equity option and warrant holders decide to exercise their options and warrants, 100 million shares would be outstanding (250,000*100 + 250,000*100) and Company ABC's share price would likely drop to $5 due to dilution of outstanding shares.

Company ABC's market capitalization is $500 million (50 million * $10) and would remain the same if all securities were to be exercised, or 100 million shares * $5; hence the likely drop to $5.

Dilution and Earnings Per Share

Similarly, the amount of fully diluted shares would affect a company's earnings per share (EPS), which is calculated by dividing net income less any dividends by its outstanding shares, using the basic calculation. The fully diluted EPS is calculated by dividing net income less any dividends paid to shareholders by its fully diluted share amount.

For example, assume Company ABC has net income of $100 million and does not pay any dividends. Its resulting basic EPS is $2, or ($100 million/50 million shares). Company ABC's fully diluted EPS would be cut in half to $1, or ($100 million/100 million shares). Investors should consider this to properly assess the company's financial stability and health.

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