Fully Diluted Shares Definition
Fully diluted shares are the amount of shares that will be outstanding and available to trade on the open market after all sources of shares conversion, like convertible bonds and employee stock options are executed. Fully diluted shares are required for a firm’s earnings per share (EPS) computations as the application of fully diluted shares increases the share basis in the measurement while reducing the dollar amount earned per unit of common stocks.
A Little More on What are Fully Diluted Shares
Fully diluted shares have substantial effects on the earnings per share (EPS) of a firm and this is a common measurement used in assessing the profitability and average value of the company. EPS is gotten from the difference between the net income and preferred dividends of the firm, divided by the weighted average of unexecuted common stocks. Mathematically, the weighted average of outstanding shares is given as:
[Starting period balance + Period ending balance] / 2.
- Fully diluted shares gives an idea or highlights the possible number of shares that will be remaining in the future, and this number or estimate is usually gotten from the current company policy regarding conversions. It is also important to note that full dilution of shares at a single moment is rare.
- The amount paid to preferred shareholders are usually subtracted as cash dividends from the net income generated by the company. This is done because earnings per shares are only applicable to common shareholders.
- Conversion policies for each firm might change over time, and this might impact estimates of future earnings per share.
The Place of Fully Diluted Shares in a Firm
Let us assume that a company CX is able to generate $2million in net income every year, and from this amount, they get to pay their preferred shareholders the sum of $900,000 in dividends. The net income in this case that would be available to common shareholders would be $1.1million. Here, if the firms weighted average of unexecuted common shares equals 200,000 units, the earnings per shares in this case would be $5.5. The value of $5.5 is gotten from $1.1 million / 200,000. In this case, $5.5 would be referred to as the basic earnings per shares as the total amount has not be computed for dilution.
When all of a firm’s security that can be converted into common shares has been converted such that the possibility for fewer earnings per share is one, then a full dilution would be said to have taken place. Investors are advised to research and review both basic earnings per shares and fully diluted earnings per shares since both factors are needed to determine a firm’s profitability and relative value.
Fully Diluted Shares: Examples
There are different securities that can be converted into common stocks, with the inclusion of convertible bonds, convertible preferred stock, employee stock options, rights, and warrants. For instance, imagine that Company CX given above has 20,000 shares in stock options that it wishes to use as a bonus to employees for their work in making the company successful. CX also has convertible outstanding bonds that allow bondholders to transform their securities into 40,000 units of common stocks. Also, the firm has a convertible outstanding preferred stock and they can convert to 40,000 units just like the securities of the bondholders.
Using full dilution, we assume that all parts of the 100,000 shares are exercised, and this increases the outstanding common shares to 300,000 (previous 200,000 shares + 100,000 shares). Now, taking the $1.1 million being paid to common shareholders and dividing it by the number of shares (300,000 in this case), we will arrive at $3.67 per share, which is smaller than the basic earnings of shares of $5.5. So the basic earnings per share (EPS) would be $5.5 per unit, while the fully diluted EPS would be $3.67 per share.