Dilutive securities are financial instruments (like options, warrants, convertible bonds, and convertible preferred stock) that can be converted into common stock, which potentially increases the number of outstanding shares in a company. If these securities are converted, they can lead to the dilution of ownership interest for existing shareholders.
Here’s a brief explanation of some common types of dilutive securities:
- Options and Warrants: These are contractual rights to buy shares of common stock at a specified price. When they’re exercised, the company issues new shares, which increases the total number of shares outstanding.
- Convertible Bonds: These are bonds that can be converted into a predetermined amount of the company’s common stock. If a convertible bondholder decides to convert their bonds into stock, this increases the number of shares outstanding.
- Convertible Preferred Stock: This type of preferred stock gives the holder the right to convert their preferred shares into a certain number of common shares. If holders of convertible preferred stock choose to convert their shares, this again increases the number of shares outstanding.
When calculating diluted earnings per share (EPS), companies must take into account all of these dilutive securities to give investors a clearer picture of what the EPS would be if all dilutive securities were exercised or converted.
Example of Dilutive Securities
Let’s take the example of a company that has issued stock options to its employees, which is a common type of dilutive security.
Let’s say XYZ Tech, a hypothetical company, has 1 million shares of common stock outstanding. They also have stock options outstanding that give employees the right to purchase a total of 100,000 additional shares at a price of $10 per share.
Currently, the market price of XYZ Tech’s shares is $15. Given this, it’s likely that the employees would exercise their options, as they could immediately make a profit by buying shares for $10 and selling them at the market price of $15.
If all of the options are exercised, this would increase the total number of outstanding shares from 1 million to 1.1 million. The existing shareholders would now own a slightly smaller percentage of the company, because their shares are now a portion of the larger total. This is an example of how dilutive securities can lead to dilution of ownership.
At the same time, when calculating diluted earnings per share (EPS), XYZ Tech would have to take into account these additional 100,000 shares. This would likely lower the diluted EPS compared to the basic EPS, which only considers the current number of shares outstanding and not potential conversions from dilutive securities.