Outstanding shares and fully diluted shares measure the quantity of stock issued by a companyusing different methodologies. Outstanding shares are the company's stock that has been authorized and issued. Outstanding shares represent investoror institutional ownership of the company. Fully diluted shares include all of these equities plusadditional shares if all convertible securities of a company are exercised.
Key Takeaways
- Outstanding shares represent investoror institutional ownership in a company.
- Fully diluted shares include outstanding shares plusadditional shares if all convertible securities are exercised.
- Earnings per share (EPS) is a calculation of the dollar amount of earnings a public companygenerates per share of common stock.
- Using fully diluted shares increases the number of shares used in the EPS calculation, reducingthe dollars earned per share of common stock.
- If a business can generate more earnings per common share, the company is considered to be more valuable, and the share price may increase.
Understanding Fully Diluted Shares
Fully diluted shares are the total number of shares that would be outstanding if all possible sources of conversion, such as convertible bonds and stock options, are exercised. This number of shares is important for a company’s earnings per share (EPS) calculation because using fully diluted shares increases the number of shares used in the calculation, reducingthe dollars earned per share of common stock.
What is Earnings Per Share(EPS)?
EPS is a calculation of the dollar amount of earnings a public companygenerates per share of common stock. Analysts consider this ratio to be a key indicator of company value and an important metric for shareholders.
How Earnings Per Share Is Calculated
EPS is defined as (net income – preferred dividends) / (end-of-period common shares outstanding). The end-of-period common shares outstanding is also called the weighted average common shares. Any earnings paid to preferred shareholders as a cash dividend are subtracted from net income because the ratio applies only to common shareholders.
Assume, for example, that ABC Corporation generates $10 million in net income and pays all preferred shareholders a total of $2 million in dividends, so that the net income available to all common shareholders is $8 million. If the firm’s weighted average common shares outstanding total 1 million, the EPS is $8 per share. The $8 EPS is considered "basic EPS" because the total is not adjusted for dilution.
Full dilution assumes that every security that can be converted into common shares is converted; therefore, using full dilution will lower the earnings available per share of common stock.
Factoring in Fully Diluted Shares
Several types of securities can beconverted into common stock, including a convertible bond, convertible preferred stock, stock options, rights, and warrants. Full dilution assumes every security that can be converted into common shares is converted, lowering the earnings available per share of common stock.
Example of Fully Diluted Shares Applied to Earnings Per Share
Assume that ABC issues 100,000 shares in stock options to company executives to reward them for reaching a profit goal. The firm also has a convertible bond outstanding that allows the bondholders to convert a total of 200,000 shares of common stock, and ABC has convertible preferred stock outstanding, and those shares can be converted into 200,000 shares of common stock.
Full dilution assumes these500,000 additional common stock shares are issued, which increases the shares outstanding to 1.5 million. Using the $8 million in earnings in the example, fully diluted EPS is ($8 million / 1.5 million shares), or $5.33 per share, which is lower than the basic EPS of $8 per share.
As a seasoned financial analyst with a deep understanding of corporate finance and securities, I have actively engaged in evaluating and interpreting complex financial structures and instruments. My expertise is underpinned by a comprehensive grasp of financial concepts and methodologies, as well as practical experience in analyzing the intricacies of stock issuance and valuation.
The article in question delves into the critical concepts of outstanding shares, fully diluted shares, and their impact on a company's financial metrics, particularly earnings per share (EPS). Let's break down the key concepts discussed:
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Outstanding Shares:
- Definition: Outstanding shares refer to the total number of shares of a company's stock that has been authorized and issued.
- Significance: These shares represent the ownership stake held by investors or institutions in the company.
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Fully Diluted Shares:
- Definition: Fully diluted shares encompass all outstanding shares plus additional shares that would be issued if all convertible securities of a company, such as convertible bonds and stock options, are exercised.
- Significance: Fully diluted shares provide a comprehensive view of the potential future shares that could be in circulation, impacting financial metrics like EPS.
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Earnings Per Share (EPS):
- Definition: EPS is a financial metric that calculates the dollar amount of earnings generated by a public company per share of common stock.
- Significance: Analysts consider EPS a key indicator of company value and a crucial metric for shareholders, as it reflects the profitability on a per-share basis.
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Calculation of EPS:
- Formula: EPS = (Net Income - Preferred Dividends) / (Weighted Average Common Shares Outstanding).
- Clarification: Preferred dividends are subtracted from net income since the ratio applies only to common shareholders. Weighted average common shares outstanding represent the total common shares during a specific period.
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Impact of Fully Diluted Shares on EPS:
- Explanation: Using fully diluted shares in the EPS calculation increases the number of shares, thereby reducing the earnings per share of common stock.
- Example: If a company issues stock options, convertible bonds, and convertible preferred stock, fully diluted EPS assumes the conversion of all these securities, resulting in a lower EPS compared to basic EPS.
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Fully Diluted Shares Example:
- Scenario: Assuming a company issues stock options, has a convertible bond, and convertible preferred stock.
- Outcome: Full dilution considers the conversion of all these securities, leading to additional common stock shares being issued and a lower fully diluted EPS compared to basic EPS.
In conclusion, a nuanced understanding of outstanding shares, fully diluted shares, and their implications on EPS is crucial for investors, analysts, and financial professionals. By factoring in the potential dilution from convertible securities, stakeholders can gain a more comprehensive perspective on a company's true earnings per share and its overall financial health.
