Definition of Diluted Shares
The total number of shares or share stock that will be available to the company if it undergoes all the sources of conversions like Employee Stock Option Plans, Convertible bond conversions and company is free to trade all stock in the open market is called as the diluted shares, and it is an important measure which is required for calculating company’s diluted earnings per share (EPS).
Explanation
Earnings per share of the company are the metric that is used for assessing the profitability and relative value of the share. If the company can increase its EPS, the value of its share increases, and its publicly traded share price may increase. However, earnings per share get affected by diluted shares. The value of the EPS decreases with the increase in the number of diluted shares. Full dilution means that every security has been converted into shares that can be converted, after which there will be fewer earnings per share available to the stockholders. This is so because the dilution of shares results in an increase in the share capital of a company without increasing the demands of shares. The shareholders’ value of their share stock can decrease in terms of percentage with the issue of dilutive shares.
How to Calculate Dilutes Shares
Calculate the number of diluted shares as follows:
- Download the annual reports of the company from authorized websites.
- Refer to the company’s balance sheet in the annual report.
- Open the stockholder’s equity section of the balance sheet to identify the number of common shares outstanding by the company.
- If the company has a number of employee stock options, find its number, strike price, or exercise price as per the footnote given in the company’s balance sheet. From the company’s current stock price, subtract its exercise price. Divide the result by the current stock price. Multiply this number by the option outstanding.
- In the case of the warrants, determine the number of warrants and then multiply it by the number of the shares in which each warrant can be converted.
- In the case of the convertible bonds, multiply it by its conversion ratio to arrive at a diluted portion of convertible bonds.
- Add the results of step 4, 5 and 6 to the number of outstanding shares in order to arrive at the figure of diluted shares.
Example of Property Plant and Equipment
Suppose there is a company by the name XYZ in corp. As per its latest books of accounts and reports, it has 50 million shares outstanding. There are employee stock options also. The number of the options outstanding is 3 million with an exercise price of $10. Assume the current stock price of the company is $20. Calculate the dilutes shares.
|
Particulars |
Value |
| Number of shares outstanding by the company (A) | 50 million |
| Number of employee options outstanding (B) | 3 million |
| Exercise price | $10.00 |
| Current stock price | $20.00 |
| Desired price($20-$10) | $10.00 |
| Current stock value ($10/$20) © | 0.5 |
| Total number of outstanding shares(0.5*3 million) (D =C*B) | 1.5 million |
| Total number of dilutes shares ( 50 million+1.5 million) (A + D) | 51.5 |
What Happens When It Dilutes Shares?
Dilution of shares increases the capital of the company. Previous to dilution, suppose we hold a certain percentage of capital in a company. As a result of share dilution, the capital of the company gets increased, but our number of shares does not get increased. Also, the demand for the shares remains the same. As a result, our shareholding in terms of percentage gets decreased as the company’s capital gets increased. The dilution of shares results in the issuance of new shares by the company, which lessens the company’s ownership percentage. Not only the percentage holdings, but shareholders have to face a decrease in the value of their shares too. The value of each individual share decreases as a result of dilution. The shareholder earns less as compared to earlier holding before dilution. The company can benefit from share dilution if it wants to launch any new business in the future and show the increased capital.
Impact of diluted shares
The below are the impacts of Dilutes shares:
- Dilutive shares impact the earning of the individual share as the company’s capital increases due to the new issue of shares while the individual holding percentage decreases. Hence the EPS of the individual get adversely affected.
- Along with EPS, the Price-earnings ratio also gets affected as the P/E ratio is directly linked with the earnings per share.
- Sometimes dilutive shares can prove to be positive also. If the company has to launch any new large line of business, it has to increased capital along with increased revenues. In this case, share dilution has a positive impact on shares in the long run.
Dilutes Shares vs Undiluted Shares
The below are some of the difference between diluted and undiluted shares.
- Diluted shares are those shares or share stock that will be available to the company after undergoing all the sources of conversions are exercised like Employee Stock Option Plans, Convertible bond conversions whereas Undiluted shares are those shares or share stock that will be available even before the other options of conversions are yet to be exercised.
- Dilutive shares earnings are calculated as:
Dilutive EPS = (Net income-Preferred dividend +Paid out dilutive securities)/ (Weighted average number of common shares outstanding conversion of dilutive securities) whereas undiluted shares earnings are calculated as Undiluted EPS = Net Earnings/Number of shares.
- The calculation of dilutive EPS is complex as compared to Calculation Dilutive EPS as in undiluted shares; we need to calculate only net earnings and the number of shares.
Advantages
Following are the advantages of diluted shares::
- Diluted shares take into account all the potential effect of conversion of dilutive securities and hence helps in the determination of EPS.
- It helps the company in comparison itself with other companies and to determine where it stands.
- As generally all the securities get captured and converted, there is less or minimal manipulation.
Conclusion – Diluted Shares
Considering the company point of view, dilution of shares is beneficial as it gives a better presentation of its capital to investors. Considering the individual, it is not as beneficial because it decreases the shareholder’s shares value in terms of the company’s total capital. However, if the shareholder has long-term investment plans in the company, dilution of shares can be proved to be beneficial for the shareholder too, as it allows the company to an expansion of its business which ultimate is beneficial for the shareholder.
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