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 easily convert into common shares.
But why do we need to know about such securities?
It has implications when you’re calculating fully 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.. Due to these securities, the earnings per share can reduce. As a result, investors may not get very attracted towards 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 shareFormula Of Diluted 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..
You can see that by taking the diluted securities into account, the diluted EPS would reduce. It can act as a bane or boon. It depends on 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, companies issue options to their employees.
Warrants are more or less similar to the options the company issues. You can also acquire warrants at a specific price and during a specified period/range of time. And stock 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. Company issues Options to the employees, whereas company issues warrant 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 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.. 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 dividendsDividendsDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company. 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 EPSBasic EPSBasic EPS represents the income of the company for each common stock. In other words, it is the value appreciation of the common shares resulting from equal distribution of the company's profit as dividends among the common stockholders. 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 securitiesAnti-dilutive SecuritiesAnti dilutive securities refer to the financial instruments initially available as convertible securities and not ordinary shares. However, converting such shares into ordinary stocks results in the higher earnings per share or an increase in shareholders' voting power.)
Dilutive Securities Video
This article 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 at the following recommended articles in accounting –