Although full dilution may not happen immediately, it estimates the potential number of outstanding shares in the future based on the current company policy for conversions. Net income is reduced by cash dividends paid to preferred shareholders since EPS only pertains to common shareholders. It is important to note that company policy for conversions may change, which could affect anticipated projections for the total number of fully diluted shares in the future.
Basics
Fully diluted shares represent the complete count of a company's common shares accessible for trading in the public market once all potential conversion sources, including convertible bonds and employee stock options, have been exercised. These shares encompass not just the presently issued ones but also those that may be obtained through conversion. Incorporating fully diluted shares into earnings per share (EPS) computations elevates the share denominator in the equation, thereby diminishing the earnings per share of common stock.
Fully Diluted Shares and EPS Impact
Fully diluted shares play a crucial role in a company's earnings per share, a key metric for evaluating its value and profitability. EPS is calculated as net income minus preferred dividends, divided by the average of common shares outstanding. This weighted average is determined by adding the beginning and ending periods balance and dividing the result by 2.
An increase in earnings per common share enhances the company's perceived value, potentially leading to a rise in the publicly traded share price. However, the EPS is adversely affected when the number of outstanding shares increases, causing a reduction in this metric.
Consideration of Fully Diluted Shares
Let's consider ABC Corporation (ABC), which reports a net income of $10 million. Out of this, $2 million is allocated to preferred shareholders as dividends, leaving $8 million available for common shareholders. With a weighted average of 1 million common shares outstanding, the basic earnings per share stand at $8.00 ($8 million / 1 million shares).
This $8.00 EPS is categorized as "basic" EPS because it doesn't account for potential dilution. On the other hand, full dilution assumes the conversion of all securities into common shares, leading to reduced earnings per share for common stock. As EPS is a critical indicator of a company's value and profitability, investors should analyze both basic and fully diluted EPS to make informed decisions.
Illustrating Fully Diluted Shares
Various securities have the potential for conversion into common stock, including convertible bonds, convertible preferred stock, employee stock options, rights, and warrants. For instance, consider ABC, which grants 100,000 stock options to employees in recognition of their outstanding performance. Furthermore, ABC holds convertible bonds that allow bondholders to transform their securities into 200,000 common stock shares. Additionally, convertible preferred stock exists, with the capability of being converted into an additional 200,000 common stock shares.
In the scenario of full dilution, assuming the issuance of all 500,000 potential common stock shares, the total common shares outstanding would reach 1.5 million. When applying the $8 million earnings to common shareholders, the fully diluted earnings per share equates to $5.33 per share ($8 million / 1.5 million shares), a reduction from the basic EPS of $8.00 per share.
Conclusion
Fully diluted shares offer a forward-looking estimate of potential outstanding shares, considering company conversion policies. Preferred dividends reduce net income, though it's vital to note conversion policies may change, impacting future projections. Understanding fully diluted shares aids investors in assessing a company's value and profitability through EPS analysis. Higher earnings per common share can boost a company's perceived value and share price, but increased outstanding shares can lower EPS. Evaluating both basic and fully diluted EPS is crucial for informed investment decisions.