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 of the diluted shares by exercising the right available with them with respect to the conversion of diluted shares into normal shares.
What are Diluted Shares Oustanding?
- Whenever these convertible parts convert into shares, it reduces the earning per share of a company and therefore called as diluted shares.
- It will result in a decrease of the shareholding percentage of the existing outstanding shareholders of the company.
Components of Fully Diluted Shares Oustanding
There are certain components in companies that have the option to convert in shareholders’ equity. The most common ones are convertible Bonds, convertible preferred stocks and employee stock options of a company.
#1 – Convertible Bonds
These are debt instruments which the company issues in order 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 prior to dilution of the convertible debentures.
#2 – Convertible Preference Shares
Preferential shares have the features of both debt and equity. It receives some fixed coupons like debt and has the claim on capital appreciation 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 prior to dilution of the preferential shares.
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#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 at a given price. Once converted they will dilute the existing shareholding pattern by reducing the percentage hold prior to 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 price.
source: Colgate 10K Filing
Fully Diluted Shares Example
Let us assume an arbitrary example in order to see how the diluted shares result in the decrease in the shareholding percentage of a shareholder prior to the issuance of such shares. Suppose the company has 10,000 outstanding shares issued 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 debts, convertible preferential shares, and equity options adds 3000 shares in the tally then the individual shareholders’ percentage holding in the equity shares of the company will come down to .8% from the earlier tally of 1%.
Fully Diluted Shares 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 EPS, which accounts for the effect of the convertible elements. It is mandatory from the regulators of countries to report both basic earnings per share which net income by the number of basic outstanding shares and diluted earnings per share which is net income by diluted outstanding shares.
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 of Diluted Shares Oustanding
- The employee stock options that result in the diluted EPS help the company to retain a performing employee, which acts a compensation and motivation for the employee.
- When a convertible debenture is converted into shares, then at times it reduces the burden of leverage for the company.
- When a convertible debenture is converted into shares, then at times it reduces the cost of capital for the company as the cost of debt is generally lesser than the cost of equity.
Disadvantages of Diluted Shares Oustanding
- This 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 reducing 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 is converted 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 of Diluted Shares Oustanding
- Outstanding diluted shares count and diluted earnings per share are only reported by public companies and not by 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, which does reflect the true value as it is based on the assumption that all the dilutive securities will get converted which not the case most of the time.
- 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.
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 –