How Do Fully Diluted Shares Affect Earnings?

Outstanding shares and fully diluted shares measure the quantity of stock issued by a company using different methodologies. Outstanding shares are the company’s stock that has been authorized and issued. Outstanding shares represent investor or institutional ownership of the company. Fully diluted shares include all of these equities plus additional shares if all convertible securities of a company are exercised. 

Understanding Fully Diluted Shares

Fully diluted shares are the total number of shares that would be outstanding if all possible sources of conversion, such as convertible bonds and stock options, are exercised. This number of shares is important for a company’s earnings per share (EPS) calculation because using fully diluted shares increases the number of shares used in the calculation, reducing the dollars earned per share of common stock.

What is Earnings Per Share (EPS)?

EPS is a calculation of the dollar amount of earnings a public company generates per share of common stock. Analysts consider this ratio to be a key indicator of company value and an important metric for shareholders.

How Earnings Per Share Is Calculated

EPS is defined as (net income – preferred dividends) / (end-of-period common shares outstanding). The end-of-period common shares outstanding is also called the weighted average common shares. Any earnings paid to preferred shareholders as a cash dividend are subtracted from net income because the ratio applies only to common shareholders.

Assume, for example, that ABC Corporation generates $10 million in net income and pays all preferred shareholders a total of $2 million in dividends, so that the net income available to all common shareholders is $8 million. If the firm’s weighted average common shares outstanding total 1 million, the EPS is $8 per share. The $8 EPS is considered “basic EPS” because the total is not adjusted for dilution.

Factoring in Fully Diluted Shares

Several types of securities can be converted into common stock, including a convertible bond, convertible preferred stock, stock options, rights, and warrants. Full dilution assumes every security that can be converted into common shares is converted, lowering the earnings available per share of common stock. 

Example of Fully Diluted Shares Applied to Earnings Per Share

Assume that ABC issues 100,000 shares in stock options to company executives to reward them for reaching a profit goal. The firm also has a convertible bond outstanding that allows the bondholders to convert a total of 200,000 shares of common stock, and ABC has convertible preferred stock outstanding, and those shares can be converted into 200,000 shares of common stock.

Full dilution assumes these 500,000 additional common stock shares are issued, which increases the shares outstanding to 1.5 million. Using the $8 million in earnings in the example, fully diluted EPS is ($8 million / 1.5 million shares), or $5.33 per share, which is lower than the basic EPS of $8 per share.