What are Fully Diluted Shares?
Fully diluted shares represent the total number of shares that will be outstanding and available to trade on the open market after all possible sources of conversion, such as convertible bonds and employee stock options, are exercised. This number of shares is needed for a company’s earnings per share (EPS) calculations because applying fully diluted shares increases the share basis in the calculation while reducing the dollars earned per share of common stock.
Understanding Fully Diluted Shares
Fully diluted shares affect the EPS of a company, which is a common metric for assessing relative value and profitability. EPS represents net income minus preferred dividends, divided by the weighted average of common shares outstanding, in which the weighted average of common shares outstanding = (beginning period balance + ending period balance) / 2.
If a company can increase earnings per common share, it is considered to be more valuable and the publicly traded share price may increase. However, the number of outstanding shares affects this metric and, when the number increases, it reduces the EPS.
- While full dilution may not occur all at once, it indicates how many shares might be outstanding in the future, based on current company policy regarding conversions.
- Earnings paid to preferred shareholders as cash dividends are subtracted from net income because EPS applies only to common shareholders.
- Company policy regarding conversions may change over time, potentially impacting expectations about the future number of fully diluted shares.
Factoring in Fully Diluted Shares
Assume that ABC Corporation (ABC) generates $10 million in net income and pays preferred shareholders a total of $2 million in dividends. The net income available to common shareholders is $8 million. If the firm’s weighted average of common shares outstanding totals 1 million, the EPS will be $8.00 per share or ($8 million / 1 million shares). This $8.00 EPS is referred to as "basic" EPS because the total is not adjusted for dilution.
Full dilution means that every security that can be converted into common shares has been converted, indicating there will be fewer earnings available per share of common stock. Since EPS is a key measure of a company’s value and profitability, it is important for an investor to review basic EPS as well as fully diluted EPS.
Example of Fully Diluted Shares
Several types of securities can be converted into common stock, including convertible bonds, convertible preferred stock, employee stock options, rights, and warrants.
Assume that ABC issues 100,000 shares in stock options to employees to reward them for strong company performance. The firm has convertible bonds outstanding that allow bondholders to convert their securities into a total of 200,000 shares of common stock. ABC also has convertible preferred stock outstanding and those shares can be converted into 200,000 shares of common stock as well.
Full dilution assumes that all 500,000 additional common stock shares are issued, which increases the common shares outstanding to 1.5 million. Applying the $8 million in earnings to common shareholders, fully diluted EPS will be ($8 million / 1.5 million shares) or $5.33 per share, which is lower than the basic EPS of $8.00 per share.