Diluted Shares

Diluted Shares can be defined as the total number of shares that the company has at a particular time that can be converted into the normal share by the holders (convertible bond, convertible preferred stock, employee stock options). It is done by exercising their right to convert such shares into ordinary shares.

Whenever these convertible parts convert into shares, it reduces the earning per share of a company. It will result in a decrease in the shareholding percentage of the existing outstanding shareholders of the company. Earnings paid to preferred shareholders are subtracted during diluted shares calculation as earnings per share (EPS) is only applicable to common shareholders.

• Diluted shares are convertible shares, like bonds, stock options, and preferred stock, that holders can turn into ordinary shares.
• Certain parts of businesses can be converted into shareholders' equity. The most popular are business employee stock options, convertible bonds, and convertible preferred stocks.
• Public firms must disclose both the primary and diluted share counts. Investors always focus on the diluted EPS figure out of the primary and diluted EPS. Although diluted, EPS does not accurately reflect the underlying value since it presupposes that all the diluted securities will be converted, which is frequently not the case.

Diluted shares are when a company issues additional shares which leads to the dilution of the ownership proportion of a current shareholder. The process of dilution can be through conversion through holders with secondary offerings or optionable securities.

Public companies are mandated to report both basic and diluted numbers 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 is not the case most of the time.

It is mandatory for all publicly listed companies to report the diluted shares outstanding 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.

Outstanding diluted shares count and diluted earnings per share only public companies report and not any private companies. Diluted earnings per share are the more conservative number, considering the worst possible scenario.

Out of the two basic and diluted EPS, investors will always look at the diluted EPS number. It reflects the true value based on the assumption that all the dilutive securities get converted, which is not the case most of the time.

There are specific components in companies that have the option to convert into shareholders' equity. The most common diluted shares outstanding are convertible Bonds, convertible preferred stocks, and employee stock options of a company.

#1 - Convertible Bonds

source: aviator.aero

Certain Bonds are convertible bonds, though most bonds are non-convertible bonds. These are debt instruments the company issues to raise capital for the company. Convertible bonds have the option to be converted into equity. Once converted, they will dilute the existing shareholding pattern by reducing the percentage hold before diluting the convertible debentures.

#2 - Convertible Preference Shares

source: Yelp

Preferential shares have the features of both debt and equity. It receives fixed coupons like debt and has a claim on capital appreciation, just like equity. Certain preferential shares are convertible preference shares. They have the option to be converted into equity. Once converted, they will dilute the existing shareholding pattern by reducing the percentage hold before diluting the preferential shares.

#3 - Employee Stock Option and Warrants

Companies provide their employees with the stock option, which acts as compensation. The employees can 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 before diluting 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

The formula to calculate diluted shares calculation for earnings per share (EPS) acts as a basis for a handful of related concepts as well. Let us understand the formula through the explanation below.

Diluted Shares EPS = Net Income – Preferred Dividends/ Total Outstanding Shares

Now that we have a basic understanding of the concept of diluted shares outstanding and its formula, let us understand how to calculate earnings per share using the formula above.

To calculate the earnings per share of a company after dilution the following steps can be used-

Firstly, Add the number of dilutive shares in total or the total number of shares that the company might hold after exercising all its share obligations.

• Secondly, it is important to keep in mind that using weighted average of shares outstanding in the specific period shall give out the most accurate results.

Let us understand the concept of diluted shares calculation with the help of a couple of examples. These examples shall give us an in-depth view of the concept and its related factors.

Example #1

Let us assume an example to see how these shares result in a decrease in the shareholding percentage before issuing such shares. Suppose the company has 10,000 outstanding shares issued to 100 shareholders.

So, in this case, each shareholder will have ownership of 1% outstanding equity shares of the company. Suppose the combination of convertible debts, preferential shares, and equity options adds 3000 shares to the tally. The individual shareholders' percentage holding in the company's equity shares will come down to .8% from the earlier tally of 1%.

Example #2

So far, we know that there are broadly two types of shareholding in a company. One of them is the basic shares that do not consider the effect of convertible elements, and the other one is the diluted EPS, which accounts for the impact of the convertible elements. The countries' regulators must report both basic earnings per share and diluted earnings per share. The former is the net income by the number of basic outstanding shares, and the latter 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.

Let us understand the advantages of diluted shares outstanding through the discussion below.

• The employee stock options that result in the diluted EPS help the company retain a performing employee, which acts as compensation and motivation for the employee.
•  When a convertible debenture converts into shares, it sometimes reduces the burden of leverage for the company.
• When a convertible debenture converts into shares, it sometimes reduces the cost of capital for the company as the cost of debt is generally lesser than the cost of equity.

Despite the various advantages mentioned above, there are a few factors from the other end of the spectrum that prove to be a hassle. Let us understand the disadvantages of diluted shares calculation through the points below.

• It will result in a decrease in the shareholding percentage of the existing outstanding shareholders of the company.
• It reduces the earning per share of a company, which affects the company's valuation.
• Sometimes options are converted into shares at a lower price due to the predetermined agreement; this reduces the earnings per share.
• When a convertible debenture converts 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.

This has been a guide to what are Diluted Shares? Here we explain its formula, how to calculate, examples, and components, advantages, and disadvantages. You can learn more about accounting from the following articles –

• Ordinary Shares Capital Definition
• Redeemable Preference Shares
• Calculate Diluted EPS
• Basic EPS vs Diluted EPS