Fully Diluted Shares
Fully diluted shares represent the total number of common shares of a company that would be outstanding and available to trade in the open market, if all possible sources of conversion, such as convertible bonds and stock options, were exercised. Essentially, it’s a measurement of what the total share count would be if all potential shares were to be issued.
Fully diluted shares take into account:
- Existing Common Shares: These are the shares that are already issued and outstanding, which are either held by investors or retained by the company as treasury stock.
- Convertible Preferred Shares: If the company has issued preferred shares that holders can convert into common shares, these are included in the fully diluted share count.
- Convertible Bonds: Some bonds can be converted into common shares under certain conditions. If such bonds have been issued, they contribute to the fully diluted share count.
- Stock Options and Warrants: If the company has granted options to employees or warrants to investors, these are included as well. Options give employees the right to purchase shares at a predetermined price. Warrants work similarly but are typically issued to investors during a funding round.
- Other Rights to Purchase Stock: This might include stock granted through an employee stock purchase plan (ESPP) or any other outstanding rights to purchase stock.
Why does this matter? The number of fully diluted shares is important because it can impact financial ratios like earnings per share (EPS) and price to earnings (P/E) ratio, which investors use to assess a company’s profitability and value. More shares outstanding (in the fully diluted scenario) means that earnings are divided among a larger number of shares, potentially lowering the EPS. This, in turn, can make the P/E ratio higher, signaling a more expensive stock price relative to earnings.
It’s important to note that while full dilution shows potential dilution, it doesn’t mean that dilution will necessarily occur, since it depends on whether those options, convertible securities, etc., are actually exercised or converted.
Example of Fully Diluted Shares
Let’s say ABC Company has the following:
- 1,000,000 common shares currently outstanding.
- 200,000 shares that could be issued if all executive stock options are exercised.
- 100,000 shares that could be issued if all convertible preferred shares are converted into common shares.
- 50,000 shares that could be issued if all convertible bonds are converted into common shares.
To calculate the total fully diluted shares, we would add up all these potential shares:
1,000,000 (common shares) + 200,000 (from stock options) + 100,000 (from convertible preferred shares) + 50,000 (from convertible bonds) = 1,350,000 fully diluted shares.
So, if all possible conversions and the exercise of options were to happen, ABC Company would have 1,350,000 shares outstanding.
This fully diluted share count can then be used to calculate fully diluted earnings per share (EPS), which would be the company’s net income divided by the number of fully diluted shares. This gives investors and analysts an idea of the company’s earnings distributed over the maximum possible number of shares.
It’s important to remember that this is a hypothetical scenario and assumes that all convertible securities and options are exercised, which may not always be the case in reality.
