Diluted Shares

What are Diluted Shares Outstanding?

Diluted Shares can be defined as the total number of shares which the company has at the particular point of time that can be converted into the normal share by the holders (convertible bond, convertible preferred stock, employee stock options). It is done by exercising the right available with them with respect to the conversion of such shares into normal shares.

  • Whenever these convertible parts convert into shares, it reduces the earning per share of a company.
  • It will result in a decrease of the shareholding percentage of the existing outstanding shareholders of the company.

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For eg:
Source: Diluted Shares (wallstreetmojo.com)

Components of Fully Diluted Shares Outstanding

There are specific components in companies that have the option to convert in shareholders’ equity. The most common ones are convertible Bonds, convertible preferred stocksConvertible Preferred StocksConvertible 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.read more, and employee stock options of a companyEmployee Stock Options Of A CompanyEmployee stock option plan (ESOP) is an “option” granted to the company employee which carries the right, but not the obligation, to buy a promised number of shares at a pre-determined price (known as exercise price). read more.

#1 – Convertible Bonds

dilutive securities - convertible bonds

source: aviator.aero

These are debt instrumentsDebt InstrumentsDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more which the company issues to raise capital for the company. Certain Bonds are convertible bonds, though most bonds are non-convertible bonds. Convertible bonds have the option to be converted into equity. Once converted, they will dilute the existing shareholding pattern by reducing the percentage hold before dilution of the convertible debentures.

#2 – Convertible Preference Shares

convertible-preferred-stock

source: Yelp

Preferential shares have the features of both debt and equity. It receives some fixed coupons like debt and has a claim on capital appreciationCapital AppreciationCapital appreciation refers to an increase in the market value of assets relative to their purchase price over a specified time period. Stocks, land, buildings, fixed assets, and other types of owned property are examples of assets.read more, just like equity. Certain preferential shares are convertible preferential shares. They have the option to be converted into equity. Once converted, they will dilute the existing shareholding pattern by reducing the percentage hold before the dilution of the preferential shares.

#3 – Employee Stock Option and Warrants

Companies provide their employees with the stock option, which acts as a compensation to the employees. The employees have the option to exercise it at a given time and a given price. Once converted, they will dilute the existing shareholding pattern by reducing the percentage hold before dilution of the Convertible stock options.

Have a look at this options table from Colgate’s 2014 10K. This table provides details of Colgate’s outstanding stock options along with its weighted average exercise priceExercise PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more.

Employee Stock Options

source: Colgate 10K Filing

Fully Diluted Shares Example

Let us assume an example to see how these shares result in a decrease in the shareholding percentage before the issuance of such shares. Suppose the company has 10,000 outstanding shares issuedShares IssuedShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet.read more to 100 shareholders.

So, in this case, each shareholder will be having ownership of 1% outstanding equity shares of the company. Suppose the combination of convertible debtsConvertible DebtsConvertible debt is a type of debt instrument that can be converted at the company's discretion into equity shares. It is a hybrid security since it combines debt and equity features and provides additional benefits to the holder.read more, convertible preferential shares, and equity options adds 3000 shares in the tally. The individual shareholders’ percentage holding in the equity shares of the company will come down to .8% from the earlier tally of 1%.

Example of Colgate

So far, we have come to know that they are broadly two types of shareholding in a company. One of them is the basic shares that do not take into consideration the effect of convertible elements, and the other one is the diluted EPSDiluted EPSDiluted 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.read more, which accounts for the impact of the convertible elements. It is mandatory from the regulators of countries to report both basic earnings per share and diluted earnings per share. Former is the net income by the number of basic outstanding shares, and the latter is net income by diluted outstanding shares.

Diluted Shares Example

Colgate’s ordinary shares were 930.8, and the effect of dilution due to stock options and restricted stock units is 9.1 million. Therefore the fully diluted share comes out to be 939.9 million.

Advantages

Disadvantages

  • It will result in a decrease of the shareholding percentage of the existing outstanding shareholders of the company.
  • It reduces the earning per share of a company that effects in lowering the valuation of the company.
  • Sometimes options are converted into shares at a very lower price due to the predetermined agreement; this reduces the earnings per share.
  • When a convertible debenture converts into shares, then at times, it increases the cost of capital for the company as the cost of debt can be higher than the cost of equity in some adverse situations.

Limitations

  • Outstanding diluted shares count and diluted earnings per share only public companies report and not any private companies.
  • Diluted earnings per share are the more conservative number, which takes into consideration the worst possible scenario.
  • Out of the two basic and diluted EPS, investors will always look at the diluted EPS number. It reflects the true value as its base on the assumption that all the dilutive securities get converted, which not the case most of the time.

Important Points

  • It is mandatory for all the publically listed companies to report the diluted number of shares and also diluted earnings per share.
  • It assumes the worst possible case and is the more conservative number.
  • Investors always consider the diluted earnings per share, not the basic earnings per share though most of the time, basic EPS gives a true reflection.

Conclusion

Public companies are mandated to report both basic and diluted number of shares. Out of the two basic and diluted EPS, investors will always look at the diluted EPS number. Though diluted, EPS does not reflect the true value as it assumes that all the dilutive securities will get converted, which not the case most of the time.

This has been a guide to what are Diluted Shares?. Here we discuss the components of the Fully Diluted Shares Outstanding along with practical examples, advantages, and disadvantages. You can learn more about accounting from the following articles –

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