The profitability of a company can be measured using basic and diluted earnings per share (EPS). For the purposes of calculating the EPS, the company's issued equity shares are taken into account. Shares of convertible debt and equity are included in dilutive earnings per share computation. For an investor, the discussion between basic EPS and diluted EPS is critical because both are necessary for a company's financial performance. Let’s dive in deeper in order to understand the key metrics of these shares.
Fully Diluted Shares
Diluted Earnings Per Share (EPS) is a measure of the remaining net profits that can be distributed to each share of common equity. For example, stocks, warrants, and convertible debt or equity instruments might potentially dilute a company's share count.
What are fully diluted shares?
A company's fully diluted share count is the total number of common shares that can be traded on the open market after all convertible bonds, and employee stock options have been executed. This includes both current shares and those that can be obtained through the conversion of existing shares. There are certain numbers of shares that must be included in a company's earnings per share calculations in order to account for fully diluted shares.
Causes of Dilution
Some of the reasons why dilution occurs are listed below:
Following-up offerings in the large markets.
Ownership change and approval.
The process of transforming bonds into securities.
At the time of acquisition or partnership, each partner receives a new share allocation.
How do Fully Diluted Shares Work?
According to existing company policy, the number of shares that could be outstanding in the future is a good indicator of how much dilution might occur. The company's conversion strategy may evolve over time, affecting estimates about the amount of fully diluted shares to be issued in the future.
Stock options, warrants, and convertible preferred stock can all be exchanged for shares of common stock.
To illustrate, let's say an enterprise decides to reward its employees by issuing 100,000 shares of stock options to them. Another 200,000 shares of the business's ordinary stock are convertible into the form of convertible bonds, which the company still has outstanding. It is worth noting that the company’s convertible preferred stock can be exchanged for 200,000 shares of common stock.
Total outstanding current shareholders will rise to 1.5 million after all 500,000 extra common shares are issued. This is what we mean by "full dilution". The fully diluted EPS ($7 million / 1.5 million shares) or $4.66 per share is lower than the basic EPS ($7.00 per share) when the $7 million in earnings are applied to common shareholders.
What is Earning Per Share (EPS)?
Earnings per share (EPS) is a significant indicator of a company's profitability and overall financial success. Basic EPS tells investors how much profit is given to each share of the company's common stock, which is valuable information for the company's investors.
An increase in the earnings per share typically signifies that the company has sufficient cash on hand to either pay out dividends or reinvestigate the business. Thus, a company's reported earnings per share might have a major impact on its stock price if they don't match expectations in the capital market.
Formula of EPS
EPS = (Net Income – Preferred Dividends) / (End-of-period common shares outstanding).
It is also known as the weighted average number of common shares in circulation at the end of the term. Preferred shareholders' dividends are deducted from net income because the ratio only affects ordinary shareholders, not the preferred shareholders.
Calculation example of EPS
Suppose ABC company makes $10 million in net profits and distributes $2 million in dividends to all preferred shareholders, leaving $8 million for common shareholders. Earnings per share are $8 for companies with 1 million weighted average ordinary shares in issue. The $8 EPS is referred to as "basic EPS" because it does not consider the company's dilution of its capital.
Fully Diluted Shares and Earnings
Using fully diluted shares increases the number of shares included in the EPS computation, lowering the dollars generated per share of ordinary stock. The value of a firm may rise if its earnings per common share are higher than the industry average.
Why is it Important to Calculate EPS?
Earnings per share (EPS) are an important way to measure how much a firm makes per share of stock, and they are commonly employed in the valuation of companies. This shows more value, as investors are more likely to buy stock in companies with higher EPS as compared to their share price.
How does dilution affect EPS?
To calculate diluted earnings per share, the company has to take into account the effects of exercising dilutive securities. It is possible to convert dilutive instruments into common stock, but only if the owner takes advantage of the option. When dilutive securities are converted into common stock, the weighted number of outstanding shares increases, reducing EPS.
Basic EPS - Basic earnings per share allows investors to understand how much of a company's net income was allocated to each ordinary stock. Companies having just common stock in their capital structures are more likely to see this information in their income statement. A company's basic earnings per share are determined by dividing the company's net income for the quarter by the weighted average number of shares in issue at the time.
Diluted EPS - Assuming all convertible securities are exercised, diluted earnings per share is a measure of the company's earnings. If all of a company's convertible securities are diluted or exercised, the company's diluted earnings per share are calculated. Diluted earnings per share are calculated by dividing net income for the period by the average number of fully diluted shares in the period. Employee stock rewards, options, convertible instruments, etc., are taken into account when calculating diluted shares.
Negative EPS - There are no profits to be made if the company's price-to-earnings ratio is negative. Basically, a company's share price cannot fall below zero. As a result, if the EPS ratio is negative, it indicates that the company is going bankrupt. Dilutive securities will not be included in EPS computation when a company experiences a loss or negative EPS period.
Calculation example of diluted shares affect earnings
Suppose ABC distributes 100,000 stock options to its employees as a way to recognize their hard work. Bondholders can convert their bonds into a total of 200,000 shares of the company's common stock through the company's currently outstanding convertible bonds. In addition to ABC's convertible preferred stock, 200,000 shares of common stock can be converted.
Assuming all 500,000 extra common stock shares are issued, the number of common shares outstanding rises to 1.5 million, resulting in full dilution. To put it another way, if you apply the $8 million in earnings to common shareholders, the fully diluted earnings per share will be $5.33, which is lower than the basic $8.00 per share.
Your firm’s shares should now be taken seriously to understand the calculation of fully diluted shares and how they operate. This could significantly influence the company's market value and earnings per share (EPS) if it is not incorporated accurately in the company's valuation.