Fully diluted shares represent the total number of common shares of a company that will be available to trade after all potential conversions from instruments like convertible bonds, preferred stock, and employee stock options are exercised. This comprehensive number is crucial for calculating a company’s earnings per share (EPS), as it increases the share count and consequently reduces the relative earnings allocated to each common share.
Understanding Fully Diluted Shares
Fully diluted shares significantly affect a company’s EPS, a vital metric for gauging value and profitability. EPS is computed by subtracting preferred dividends from net income and dividing the result by the weighted average of common shares outstanding. The formula essentially being:
EPS = (Net Income - Preferred Dividends) / Weighted Average of Common Shares Outstanding
A higher EPS indicates greater profitability per share, which could boost share prices. However, an increase in the number of outstanding shares due to dilution will lower the EPS, thus influencing the company’s estimated value.
Key Takeaways
- Fully diluted shares indicate the total potential shares outstanding in the future under current company policies on conversions.
- Preferred dividends are subtracted from net income in EPS calculations since EPS pertains to common shareholders alone.
- Policies on conversions can shift, affecting the expected count of fully diluted shares.
Factoring in Fully Diluted Shares
Consider ABC Corporation, which earns $10 million in net income and pays $2 million in preferred dividends. The remaining $8 million is allocated to common shareholders. If the company has a weighted average of 1 million common shares outstanding, the basic EPS is:
Basic EPS = $8 million / 1 million shares = $8.00 per share
Full dilution accounts for all convertible securities transforming into common shares, thereby reducing the EPS. Investors should always assess both basic and fully diluted EPS to get a comprehensive picture of a company’s financial health.
Example of Fully Diluted Shares
Imagine ABC Corporation issues 100,000 stock options to employees as incentives for strong performance. Additionally, there are convertible bonds and preferred stocks that allow conversion into 200,000 shares each, resulting in a potential addition of 500,000 shares to the common stock pool.
Under full dilution, a total of 1.5 million shares (1 million current + 500,000 additional) would be outstanding. Consequently, the fully diluted EPS would be:
Fully Diluted EPS = $8 million / 1.5 million shares = $5.33 per share
This clearly shows that while the basic EPS stands at $8.00 per share, the fully diluted figure drops to $5.33 per share, reflecting the dilution impact.
Related Terms: EPS, convertible bonds, stock options, net income, investor.
