What are Anti Dilutive Securities
Anti-Dilutive Securities can be defined as those financial instruments that the company has at the particular point of time which are not in common stock form but if they are converted into the common stock, then that would result in an increase in the earning per share of the company.
Let’s take an example to illustrate how the anti-dilutive securities work and how to treat the anti-dilutive securities while calculating the diluted EPS.
Company R has issued a convertible bond of 250 at $200 par issued at par for a total of $50,000 with a yield of 15%. Company R has mentioned that each bond can be converted into 20 shares of common stock. The weighted average outstanding number of common shares is 16000. The net income of Company R for the year is $20,000, and the paid preferred dividends are $4000. The tax rate is 25%.
Find out the basic EPS and the diluted EPS. And compare the two.
In the above example, first, we will calculate the earnings per shareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is. for the Company R.
- Earnings per Share (EPS) = Net Income – Preferred Dividends / Weighted Average Number of Common SharesWeighted Average Number Of Common SharesWeighted Average Shares Outstanding is a calculation used to estimate the variations in a Company’s outstanding shares during a given period. It is determined by multiplying the outstanding number of shares (consider issuance & buybacks) in a given reporting period with their individual time-weighted portions. .
- Or, Basic EPS = $20,000 – $4000 / 16000 = $16,000 / 16,000 = $1 per share.
To compute the diluted EPS, we need to calculate two things.
- First, we will calculate the number of common shares that would be converted from the convertible bonds. In this situation, for each convertible bond, 40 common shares would be issued. If we convert all of the convertible bonds into common shares, we will get = (250 * 20) = 5,000 shares.
- Second, we need to find out the earnings from the convertible bonds as well. Here’s the earnings = 250 * $200 * 0.15 * (1 – 0.25) = $5625.
Now, we will calculate the diluted EPS of Company R.
Diluted EPS = Net Income – Preferred DividendsPreferred DividendsPreferred dividends refer to the amount of dividends payable on preferred stock from profits earned by the company, and preferred stockholders have priority in receiving such dividends over common stockholders. + Earnings from the Convertible Bonds / Weighted Average Number of Common Shares + Converted Common Shares from Convertible Bonds.
- Diluted EPS = $20,000 – $4,000 + $5625 / 16,000 + 5000
- Diluted EPS = $21,625 / 21,000 = $1.03 per share.
If, by any chance, the fully diluted EPS is more than the basic EPS, then the security is anti-dilutive securities.
- In the above example, we saw that the convertible bonds are anti-dilutive securities because the basic EPS (i.e., $1 per share) is less than the dilutive EPS ($1.03 per share) when we take the convertible bonds into account.
When a company has anti-dilutive security like the above example, it excludes the anti-dilutive securities from the calculation of diluted earnings per shareDiluted Earnings Per ShareDiluted EPS is a financial ratio to check the quality of the Earnings per Share after taking into account the exercise of Convertible Securities like Preference Shares, Stock Option, Warrants, Convertible Debentures etc..
How to check if Convertible Debt is an Anti Dilutive Security?
Before calculating diluted EPS, one needs to check if this security is anti-dilutive. To check whether the convertible debt is anti-dilutive, calculate
- If this ratio is less than basic EPS, convertible debt is dilutive security and should be included in the calculation of diluted EPS.
- If this ratio is greater than the basic EPS, then the convertible debt is anti-dilutive security.
How to check if Convertible Preferred stock is an Anti Dilutive Security?
To check whether the convertible preferred stockThe Convertible Preferred StockConvertible preferred stocks are a special class of stocks which give the right to convert its preferred stock holding into fixed numbers of shares of company's common stock after the predetermined period. These are hybrid instruments with fixed dividends, providing options to acquire common stock. is anti-dilutive, calculate
- If this ratio is less than basic EPS, a convertible preferred stock is dilutive and should be included in the calculation of diluted EPS.
- If this ratio is greater than the basic EPS, then the convertible preferred stock is anti-dilutive security.
Video on Anti Dilutive Securities
This has been a guide to what is anti-dilutive securities. Here we discuss how convertible debt and preferred stock can become anti-dilutive security with examples. You may also learn more about Corporate Finance from the following recommended articles –