Dilutive Securities

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.read more. Due to these securities, 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.read more 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.read more.

dilutive securities formula

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

Dilutive Securities

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Source: Dilutive Securities (wallstreetmojo.com)

#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.

Employee Stock Options

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.read more. By owning convertible bonds, the owners can convert them into common stock.

dilutive securities - convertible bonds

source: aviator.aero

#3 – Convertible preferred stocks:

As the name suggests, these are preferred stocks. These stocks pay dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more too. But if the owners of these convertible preferred stocks want, they can convert their preferred stocks into common stocks.

convertible-preferred-stock

source: Yelp

Conclusion

Dilutive securities are more important because companies issue convertible securitiesConvertible SecuritiesConvertible securities are securities or investments (preferred stocks or convertible bonds) that can be easily converted into a different form, such as shares of an entity's common stock, and are typically issued by entities to raise money. In most cases, the entity has complete control over when the conversion occurs.read more 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.read more 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.read more)

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 –