What are Diluted Shares Outstanding?

  • Whenever these convertible parts convert into shares, it reduces the earning per share of a company.It will result in a decrease of the shareholding percentage of the existing outstanding shareholders of the company.

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Components of Fully Diluted Shares Outstanding

There are specific components in companies that have the option to convert into shareholders’ equity. The most common ones are convertible Bonds, convertible preferred stocksConvertible Preferred StocksConvertible preferred stocks are a special class of stocks which give the right to convert its preferred stock holding into fixed numbers of shares of company’s common stock after the predetermined period. These are hybrid instruments with fixed dividends, providing options to acquire common stock.read more, and employee stock options of a companyEmployee Stock Options Of A CompanyEmployee stock option plan (ESOP) is an “option” granted to the company employee which carries the right, but not the obligation, to buy a promised number of shares at a pre-determined price (known as exercise price). read more.

#1 – Convertible Bonds

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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

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Preferential shares have the features of both debt and equity. It receives fixed coupons like debt and has a claim on capital appreciationCapital AppreciationCapital appreciation refers to an increase in the market value of assets relative to their purchase price over a specified time period. Stocks, land, buildings, fixed assets, and other types of owned property are examples of assets.read more, 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 priceExercise PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more.

source: Colgate 10K Filing

Fully Diluted Shares Example

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 issuedShares IssuedShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner’s equity on the Company’s balance sheet.read more 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 debtsConvertible DebtsConvertible debt is a type of debt instrument that can be converted at the company’s discretion into equity shares. It is a hybrid security since it combines debt and equity features and provides additional benefits to the holder.read more, 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 of Colgate

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 EPSDiluted EPSDiluted EPS is a financial ratio to check the quality of the Earnings per Share after taking into account the exercise of Convertible Securities like Preference Shares, Stock Option, Warrants, Convertible Debentures etc.read more, which accounts for the impact of the convertible elements. The countries’ regulators must report both basic earnings per shareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company’s performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more  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 unitsRestricted Stock UnitsRestricted Stock Units or RSU can be defined as stock-based compensation that is issued as company’s stock to an employee. The company establishes vesting requirements based on the performance of an individual and the length of the employment.read more is 9.1 million. Therefore the fully diluted share comes out to be 939.9 million.

Advantages

  • 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 equityCost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more.

Disadvantages

  • 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.

Limitations

  • 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 securitiesDilutive SecuritiesDilutive securities are the total number of securities (like stock options, convertible bonds) which the company has at a particular point of time that can be converted into the normal securities by the holders of such security by exercising the right available with them concerning conversion.read more get converted, which is not the case most of the time.

Important Points

  • It is mandatory for all the publicly listed companies to report the diluted number of shares 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.

Conclusion

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.

This has been a guide to what are Diluted Shares?. Here we discuss the components of the Fully Diluted Shares Outstanding along with practical examples, advantages, and disadvantages. You can learn more about accounting from the following articles –

  • Ordinary Shares Capital DefinitionRedeemable Preference SharesCalculate Diluted EPSBasic EPS vs Diluted EPS