What Are Fully Diluted Shares? Calculating Shareholder Dilution

What Are Fully Diluted Shares?

Fully diluted shares represent the total number of common shares that would be outstanding and available to trade on the open market if all possible sources of conversion are exercised. Fully diluted shares include not only those currently issued but also all that could be created through conversions. 

The types of convertible securities that contribute to dilution are convertible bonds, convertible preferred stock, employee stock options, rights, and warrants. Companies use the fully diluted share count to calculate earnings per share (EPS). When the number of shares increases, EPS decreases because the earnings are spread over more shares.

When evaluating company value and making informed decisions, it's important to understand the impact of fully diluted shares on financial metrics, particularly the effect on earnings per share (EPS). For example, dilution can lower EPS by spreading earnings over a larger number of shares.

The Impact of Fully Diluted Shares on Earnings Per Share

Fully diluted shares impact a company’s EPS, a crucial measure of value and profitability. EPS is calculated by dividing net income (minus preferred dividends) by the weighted average of common shares. The weighted average is usually:

(beginning period balance + ending period balance) / 2

If a company increases earnings per common share, it is generally considered more valuable, which may lead to a rise in its publicly traded share price. As the number of outstanding shares plays a key role in the EPS calculation, it’s important to be aware of any potential dilution that can reduce the EPS.

How to Calculate Fully Diluted Earnings Per Share

Suppose ABC Corporation earns $10 million in net income and pays $2 million in preferred dividends. This leaves $8 million for common shareholders. With 1 million common shares, the EPS is $8.00.

$8 million / 1 million shares = $8 per share

The $8.00 EPS is "basic" because it hasn't been adjusted for dilution.

Full dilution assumes all convertible securities like stock options and bonds convert to common shares, increasing the share number and lowering earnings per share. It's important for investors to compare basic EPS and fully diluted EPS, as EPS measures value and profitability.

Practical Example: Calculating Fully Diluted Shares

Several types of securities can be converted into common stock, including convertible bonds, convertible preferred stock, employee stock options, rights, and warrants.

Suppose ABC Corporation, which has 1 million shares, gives 100,000 stock options to employees for good performance. It has convertible bonds that can become 200,000 more shares, and convertible preferred stock that can also become 200,000 shares.

With full dilution, 500,000 more shares are issued, increasing the total to 1.5 million. Applying the $8 million earnings to this total results in a fully diluted EPS of $5.33 per share, lower than the basic EPS of $8.00.