What are Dilutive Securities?
Dilutive Securities can be defined as a total number of the securities (like stock options, convertible bonds etc) which the company have at the particular point of time that can be converted into the normal securities by the holders of such security by exercising the right available with them with respect to conversion.
In simple terms, we call the financial instruments as dilutive securities if they increase the number of outstanding shares. What does that mean? It means that such securities are those instruments that can be easily converted into common shares.
But why do we need to know about such securities?
It has implications when you’re calculating fully diluted earnings per share. Due to these securities, the earnings per share can be reduced. As a result, the investors may not get very attracted toward investing in the company.
However, it has a good side as well. The company offers diluted securities with a purpose of conversion. If a company is new in the business, there is a lot of upsides. That’s why many investors get attracted to the conversion feature of diluted securities and buy them.
To understand how diluted EPS works; let’s have a look at the formula of diluted earnings per share.
You can clearly see that by taking the diluted securities into account, the diluted EPS would be reduced. This can act as a bane or a boon. It depends how an investor looks at the shares of the company.
Types of Dilutive Securities
#1 – Options & Warrants
Options give the holders the option to buy the share at a specific price and during a certain period. Generally, options are issued to the employees of the company.
Warrants are more or less similar to the options the company issues. Warrants also can be acquired at a specific price. Warrants can also be purchased during a certain period/range of time. And warrants can also be converted into common stocks. The only difference between the warrants and the options is the parties they’re being issued to. Options are issued to the employees of the company; whereas the warrants are issued to the individuals outside of the company.
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
#2 – Convertible Bonds
Convertible bonds are debt instruments. By owning convertible bonds the owners can convert them into common stock.
#3 – Convertible preferred stocks:
As the name suggests, these are preferred stocks. These stocks pay dividends too. But if the owners of these convertible preferred stocks want, they can convert their preferred stocks into common stocks.
Dilutive securities are more important because companies issue convertible securities to attract investors. The basic EPS is always more than the diluted earnings per share. If the basic EPS is less than the diluted EPS, then that particular diluted securities would be removed from the calculation of diluted earnings per share (anti-dilutive securities)
Dilutive Securities Video
This has been a guide to what is Dilutive Securities. Here we discuss the types of dilutive securities including convertible bonds, convertible preferred stocks, Options and Warrants with examples. You may also have a look the following recommended articles in accounting –