What are Fully Diluted Shares
Fully diluted shares is the total number of shares that would be outstanding if all possible sources of conversion, such as convertible bonds and employee 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
Fully diluted shares affect the EPS of a company, which is a common metric for assessing a company's value.
How Earnings Per Share Is Calculated
EPS is net income minus preferred dividends, divided by weighted average common shares outstanding.
Earnings paid to preferred shareholders as cash dividends are subtracted from net income because EPS applies only to common shareholders.
Weighted average common shares is (beginning period balance + ending period balance) / 2.
If a business can increase earnings per common share, the company is considered to be more valuable and the share price may increase. But the number of shares also affects the metric. If outstanding shares increase, that will drag down the EPS.
Assume that ABC Corporation 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 common shares outstanding total 1 million, the EPS is $8 per share ($8 million / 1 million) shares. 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 as well as fully diluted EPS.
Several types of securities are converted into common stock, including convertible bonds, convertible preferred stock, employee 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 increasing stock performance. The firm has convertible bonds outstanding that allow the bondholders to convert their bonds 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.
Full dilution assumes that all 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.
While full dilution may not occur all at once, it lets investors know how many shares could be potentially outstanding in the future, based on current company policy. Since company policy may change over time, shares outstanding and fully diluted shares may also change over time. It is a not a static number.