Calculating earnings per share is more complicated than dividing net earnings by the number of shares outstanding. You must first define “outstanding shares.” If you calculate undiluted EPS, outstanding shares may mean the common shares issued during an initial public offering or it might mean primary shares, which include all common shares issued during an IPO and any follow-on offerings held by investors. If you want to assess fully diluted EPS, outstanding shares might also include shares that will be outstanding if all warrants and options are exercised, all contingent shares are issued and all convertible bonds and stock are converted into shares at a particular time.
At its founding or after a follow-on stock offering, a corporation has a pool of stock that consists of a finite number of outstanding shares, each of which was issued for the first time and is in the hands of a shareholder. These shares are the only shares considered in the calculation of undiluted earnings per share, which equals net earnings divided by the number of shares outstanding. Excluded from this equation are contingent shares that might be issued, warrants or options that might be exercised and bonds or stock that might be converted to common stock.
Stock dilution occurs when a company increases the existing pool of outstanding common shares. If the number of outstanding shares increases while the demand remains the same, the follow-on offering will dilute the share value. For example, assume that 100,000 shares of Company Z's $10 par value common stock are outstanding and that each share has a market value of $20 per share. If the company issues another 100,000 shares, the value of the shares will be diluted to approximately $10 per share. Stock dilution can occur if a company issues additional common shares with a follow-on offering, if owners exercise stock options or warrants and if convertible bonds or preferred shares are converted to stock. Investors monitor any dilution, because the process affects stock positions, including the ownership percentage, voting control, earnings per share and the value of individual shares.
Fully Diluted Shares
Fully diluted shares are those that are outstanding when all the securities that can be converted, such as stock options and convertible bonds, are converted to common stock. Investors monitor the fully diluted share value, because the exercise of warrants and options and the conversion of bonds or preferred shares can result in a large decrease in the share price and the earnings per share. For example, assume that the ABC corporation has 100,000 shares outstanding valued at $10 per share, 50,000 options outstanding and 25,000 convertible bonds outstanding. Also assume that each option grants the holder the right to purchase one share and each bond is convertible to two shares. If the options are exercised and the bonds are converted, 200,000 shares will be outstanding at a probable value of $5 per share.
Diluted Earnings Per Share
Companies with complex capital structures report both earnings per share and diluted earnings per share. When calculating the diluted EPS, rather than basing the calculation on outstanding common stock only, investors assume the exercise of stock options and warrants and the conversion of convertible bonds and preferred stock. Earnings per share is then calculated by dividing net income minus preferred stock dividends for a period by the average number of shares of common stock that would be outstanding if all convertible securities were converted into shares of common stock. Common stock investors rely on the diluted EPS to identify the lowest possible EPS they might receive based on the company’s current earnings if securities are exercised or converted.
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