Picture this: You are the contented holder of a particular company’s stock at $20 per share. You wake up the next morning to find your shares have decreased in value even though the company’s financials haven’t changed. What happened? The company diluted its shares, reducing your investment’s strength by introducing new stock for investors and employees. However, this situation isn’t a cause for panic. You can determine the financial value of your investment by calculating the amount of fully diluted shares. Here’s what you need to know but you can also work with a financial advisor to help you understand all of your assets better and to make a long-term financial goal.
What Are Fully Diluted Shares?
Fully diluted shares refer to the total number of shares that would be outstanding if all potential sources of dilution were exercised or converted into common shares. This concept is essential for investors and analysts to regard when evaluating a company’s capital structure and the impact on ownership and earnings per share (EPS). Counting these shares provides a more comprehensive view of the company’s equity ownership than solely looking at the current outstanding shares.
To calculate fully diluted shares, add the number of common shares the company would issue upon the exercise or conversion of all the potentially dilutive securities mentioned above to the current number of outstanding common shares. This calculation helps stakeholders assess the potential impact of dilution on their ownership and the company’s financial metrics.
How Are Fully Diluted Shares Calculated?
Calculating fully diluted shares means adding together all the common shares and special securities investors hold. For example, say the company in question has 4 million common shares available in the market. Furthermore, the company provides 500,000 shares in stock options, 250,000 shares through convertible securities and 250,000 more in employee stock options. Therefore, the total common shares are 5 million.
Identify Eligible Options and Securities
Sources of dilution are the eligible options and securities that turn into common stock. They typically include:
- Stock Options: Companies can allow employees, contractors, consultants and investors to purchase a specific number of shares at a favorable price. Shares in this scenario are known as stock options and they increase the total number of outstanding shares.
- Convertible Securities: Holders of convertible securities can convert them into common shares at a predetermined conversion ratio. One type of security is a convertible bond. Counting the fully diluted shares means acting as though all existing convertible securities turned into stock.
- Warrants: A warrant is a contract allowing an investor to purchase stock at a preferential price. When warrant-holders exercise this right, the number of outstanding shares increases. However, warrants have an expiration date, meaning the investor must act on the contract before the specified date.
- Restricted Stock Units (RSUs): RSUs are stocks that companies commit to providing to employees upon meeting particular vesting requirements. When RSUs vest and are settled in shares, they contribute to the fully diluted share count.
- Employee Stock Purchase Plans (ESPPs): ESPPs allow employees to purchase company stock at a discounted price. If employees participate in these plans and acquire shares, it increases the fully diluted share count.
Diluted Shares Impact on Earnings Per Share (EPS)
You can calculate each stockholder’s earnings per share (EPS) by dividing the company’s net income (minus dividend payments) by the fully diluted share count. Using the fully diluted share count of 5 million will serve to continue with the example from above.
Say the company posts $23 million net income for the year. It pays preferred shareholders $3 million, meaning the net income to divide amongst the remaining stock is $20 million. So, you divide the net income after dividends ($20 million) by the total common shares (5 million) for a $4.00 EPS adjusted for dilution.
Advantages and Disadvantages of Fully Diluted Shares
Diluting stock has pros and cons for companies and shareholders. Here are the advantages:
- Capital Infusion: Diluting stock is a way for a company to raise additional capital. By issuing more shares and selling them to investors, the company can generate funds to finance its operations, invest in growth opportunities, or fund research and development.
- Reduced Debt Burden: If a company has a significant amount of debt, issuing new shares can be a way to reduce its debt burden. The proceeds from the stock sale can reduce or eliminate debt, leading to lower interest expenses and improved financial stability.
- Acquisition and Expansion: Stock dilution can facilitate mergers and acquisitions. By issuing shares to acquire another company, the acquiring company can expand its operations and improve revenue, leading to increased shareholder value.
- Employee Incentives: Incentive stock options, restricted stock units (RSUs) and other equity-based compensation plans can attract and retain talented employees. These equity incentives can align employee interests with those of shareholders and motivate employees to contribute to the company’s success.
It’s also important to analyze where these shares might not benefit you. Here are the disadvantages:
- Ownership Dilution: The most obvious disadvantage of stock dilution is that it reduces the ownership stake of existing shareholders. When new shares are issued, each existing shareholder’s percentage ownership in the company decreases, requiring them to purchase more stock to maintain the same level of ownership. Otherwise, new investors will snap up shares and get themselves a piece of the pie.
- Earnings Per Share (EPS) Impact: Stock dilution negatively affects a company’s (EPS) because more shares are now outstanding. A lower EPS can lead to a lower stock price, reducing the value of your investment.
- Dilution of Control: If significant stock dilution occurs, it can result in a loss of control for existing shareholders, especially if new shareholders have different agendas or voting preferences.
- Market Perception: Investors may view stock dilution as a signal that the company needs capital urgently or lacks other means to finance its operations. This perception can negatively impact the company’s stock price and reputation.
Understanding fully diluted shares and their implications is a valuable tool for both companies and investors in the dynamic world of corporate finance. A higher number of fully diluted shares can lead to a lower EPS, which may affect investor sentiment, market perceptions and stock price. However, diluting stock can provide advantages such as raising capital, reducing debt and motivating employees through equity-based compensation plans. As a result, diluted shares aren’t a reason to jump ship when investing, but it’s crucial to account for them when calculating your return on investment.
Tips for Investing
- The stock market is constantly in flux, and it can be challenging to understand what companies are worth an investment. To create a diversified, robust portfolio, talk to a financial advisor. You’ll learn about how share dilution can affect your assets and how to weather economic turbulence. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If diluted shares sound like a drag, don’t worry – there are other ways to invest in stock. For example, you can invest in an IPO to get the first crack at company shares.
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