Definition of Dilutive Securities
Dilutive securities are financial instruments like debentures, bonds, and preference shares, etc. which have the option of conversion to common stock or normal securities at a certain point of time. If the option is exercised, it will reduce the earning per share for existing shareholders, thus it is called dilutive. In simple words, if the company’s outstanding number of shares increases, it will automatically reduce the earning per share.
A company issues dilutive security for various reason, one of them is that securities with an option of conversion to common stock at a later date attract investors, as the option may seem less risky to them. The earnings per share of a company is calculated through a simple formula i.e. total earnings divided by the no. of outstanding shares. Thus now, it can be easily understood as to why dilutive securities will reduce earnings per share if the conversion option is exercised by the investor.
The existing shareholder’s ownership share or percentage is reduced as an effect of increased share capital, which is why shareholders resist dilution. This phenomenon impacts existing shareholders voting rights as well. It has other impacts as well which we will discuss in detail in later heading.
Example of Dilutive Securities
Let us suppose a company had common stocks of $4 million, options & warrants of $0.5 million, preferred share stocks $1million, and convertible bonds of $0.5 million. Total earnings for the period were $8 million. Now the company’s dilutive securities total amounts to $2 million ($0.5 million + $1 million + $0.5 million) for options & warrants, preferred share stocks, and convertible bonds respectively.
- Total Earnings for The Period: $8 million
- Basic EPS: $2 per share ($8 million ÷ $4 million)
- Diluted EPS: $1.33 per share i.e. total earnings ÷ (common stock + dilutive securities).
Types of Dilutive Securities
Below are some of the main types of dilutive securities:
1. Options and Warrants
Options are the contracts issued to the employees of the company in which they get the option to buy stocks of the company at the specified price during a certain period of time. Warrants are similar to options and the only difference is that they are not issued to employees, instead, they are issued to the outsiders or the public.
2. Convertible Bonds
Convertible bonds are the debt instruments with a fixed rate of return and an option of conversion to the common stock at the end of the period or during a certain period.
3. Convertible Preferred Stocks
Convertible preference stocks are preference shares with a fixed rate of return similar to bonds and an option of conversion to common stock at a later date. Preference stockholders are shareholders for the company and are preferred over common stockholders at the time of liquidation.
Impact of Dilutive Securities
If the option of conversion is exercised for dilutive securities by the investors it will increase the number of outstanding shares in the company and will reduce the earning per share. This situation can have several impacts which are discussed as follows:
- Earnings per share (EPS) is considered as a metric to measure the financial health of the company. The lower EPS in comparison to the previous period is not considered a good sign by the investors.
- Earnings per share is reported on the income statement of the company and public companies that are required to report EPS, report both EPS as well as diluted EPS. Diluted EPS is more focused upon by the investors as it points towards the worst-case scenario for the EPS.
- A huge difference between basic and dilutes EPS can indicate more inclination of the company towards dilution in the near future, which is not a very attractive attribute for the investors.
- Reduction or dilution in EPS is a point of concern for shareholders as their percentage claim over the company as well as their voting rights gets diminished due to this.
Dilutive Securities vs Anti Dilutive Securities
Dilutive securities lead to a reduction in earnings per share when the investor chooses to exercise the option to convert his/her current securities into common stock. Since the exercised option results in lowering down earnings per share of the company, the securities are named as dilutive securities.
On the other hand, there are some securities which leave a completely opposite impact on earnings per share of an organization, when the option of conversion is exercised by the investor, these securities will lead to an increase in the earnings per share of the company. In anti-dilutive securities, there is a provision that allows existing shareholders to buy additional shares when conversion options on dilutive securities are exercised by the investors. These types of securities are known as anti-dilutive securities.
Some of the advantages are given below:
- Dilutive securities attract investors with its option of conversion to common stock at a later date and thus help in raising finance, especially for start-up companies.
- Companies’ investment in dilutive securities and dilutive earnings per share helps investors in making investment decisions.
- Investment in dilutive securities is also one of the criteria to analyze the company’s financial health. This is done through the analysis of the difference between basic and dilutive earnings per share.
Dilutive securities are an important aspect of the company’s share capital as it helps in attracting investors who consider these securities as a less risky option. The company’s dilutive earnings per share is always lower than basic earnings per share. But in the practical world dilutive securities is more of a theoretical concept as the investors will not exercise the option unless the purchase price will generate profit for them. But since strike prices are kept higher than the market price, investors do not exercise the option.
This is a guide to Dilutive Securities. Here we discuss the definition and types of dilutive securities along with Example and advantages. You may also have a look at the following articles to learn more –