What are Dilutive Securities?

In simple terms, we call the financial instruments dilutive securities if they increase the number of outstanding shares. What does that mean? It means that such securities are those instruments that can easily convert into common shares.

But why do we need to know about such securities?

It has implications when you’re calculating fully diluted earnings per shareDiluted Earnings Per ShareDiluted 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. Due to these securities, the 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 can reduce. As a result, investors may not be attracted to investing in the company.

If a company is new in the business, there are a lot of upsides. However, it has a good side as well. The company offers diluted securities with the purpose of conversion. That’s why many investors get attracted to the conversion feature of diluted securities and buy them.

To understand how diluted EPS works, let’s look at the formula of diluted earnings per shareFormula Of Diluted Earnings Per ShareDiluted 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.

You can see that by considering the diluted securities, the diluted EPS would reduce. It can act as a bane or boon. It depends on how an investor looks at the shares of the company.

Types of Dilutive Securities

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#1  – Options & Warrants

Options allow holders to buy the share at a specific price and during a certain period. Generally, companies issue options to their employees.

Warrants are more or less similar to the options the company issues. You can also acquire warrants at a specific price and during a specified period/time. And stock warrants can also be converted into common stocks. The only difference between the warrants and the options is the parties they’re being issued to. The company issues Options to the employees, whereas the company issues warrants to the individuals outside the company.

Have a look at this options table from Colgate’s 2014 10K. This table details Colgate’s outstanding stock options and its weighted average exercise price.

source: Colgate 10K Filing

#2 – Convertible Bonds

source: aviator.aero

#3 – Convertible preferred stocks:

As the name suggests, these are preferred stocksPreferred StocksA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more. These stocks pay dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more too. But if the owners of these convertible preferred stocks want, they can convert their preferred stocks into common stocks.

source: Yelp

Conclusion

Dilutive securities are more important because companies issue convertible securitiesConvertible SecuritiesConvertible securities are securities or investments (preferred stocks or convertible bonds) that can be easily converted into a different form, such as shares of an entity’s common stock, and are typically issued by entities to raise money. In most cases, the entity has complete control over when the conversion occurs.read more to attract investors. The basic EPSBasic EPSBasic EPS represents the income of the company for each common stock. In other words, it is the value appreciation of the common shares resulting from equal distribution of the company’s profit as dividends among the common stockholders.read more is always more than the diluted earnings per share. If the basic EPS is less than the diluted EPS, then that particular diluted securities would be removed from the calculation of diluted earnings per share (anti-dilutive securitiesAnti-dilutive SecuritiesAnti dilutive securities refer to the financial instruments initially available as convertible securities and not ordinary shares. However, converting such shares into ordinary stocks results in the higher earnings per share or an increase in shareholders’ voting power.read more)

Dilutive Securities Video

This article has been a guide to what Dilutive Securities are. Here we discuss the types of dilutive securities, including convertible bonds, convertible preferred stocks, Options, and Warrants, with examples. You may also have a look at the following recommended articles in accounting –

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