The term "fully diluted shares" refers to the number of shares that would be outstanding if all financial instruments that can be converted into shares or used to purchase shares were fully used. Such instruments include employee stock options, warrants and convertible bonds. By accounting for all possible shares that could be held by investors, analysts aim to anticipate the worst possible outcome for the company's stock. The larger the number of shares outstanding, the less the profit per share will be and therefore the lower the price for those shares could go.
Start With The Stock Options
Determine the number of stock options granted to employees and other stakeholders. Since employee stock options can only be exercised if the individual is still employed by the firm and meets certain other requirements, options granted to employees who are no longer with the firm or otherwise have lost their rights to exercise their rights to buy shares at pre-determined prices must be subtracted from the total. If other stakeholders, such as outside investors, were given stock options, these must be added to the total number. Each option granted will specify how many shares the option holder can buy using these options. Add up the total number of shares that all outstanding and valid options grant rights to.
Weigh Up the Warrants
Determine the number of warrants and multiply this figure by the number of shares each warrant can be converted into. Warrants are similar to employee stock options, but they are sold for cash, as opposed to being granted to employees as a form of compensation. They function in the same way, however; each warrant gives the holder the right to buy a pre-specified number of shares at a certain price. Multiply the number of warrants sold and as yet un-exercised by the number of shares each one can be converted into.
Consider the Convertible Bonds
Find the number of convertible bonds issued by the company and not yet exercised or expired. Convertible bonds are a special class of financial instruments. They pay periodical interest like conventional bonds, but they can also be exchanged for shares at no extra cost. Find the number of all such bonds issued, which are still outstanding, along with their expiration dates and conversion ratios. The conversion ratio is the number of shares the investor will obtain by surrendering the bonds. Multiply the number of unexpired convertible bonds by the conversion ratio.
Calculate Fully Diluted Shares
Add the figures calculated in all the previous steps. The resulting number is how many additional shares there will be if the maximum possible dilution takes place. Add this figure to the current number of outstanding shares to arrive at the fully diluted share count.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.