Investors who have looked at stock reports would come across the term “diluted shares.” This is a crucial concept you as an investor need to understand. It could provide a more comprehensive view of a company’s true share count. You’ll also learn its possible impact on stock value.
Investors, even new ones, are familiar with the basic shares concept. Diluted shares are different. They consider all potential shares that could become issued in the future. This can include shares from stock options, convertible securities, and warrants.
So what are diluted shares and how will they affect a shareholder? This post will answer those questions.
What Are Diluted Shares?
They refer to the number of outstanding shares if a company uses all dilution sources. These sources refer to convertible securities, stock options, or warrants. They’re considered “potential” as they represent stock a company might issue in the future.
A fully diluted share count covers all outstanding shares. These shares will only happen if investors use their right to convert or exercise a stock claim. Diluted shares give investors a better grasp of a company’s true share count. A true share count could differ from the basic number of outstanding shares at a specified time.
How Do Companies Create Diluted Shares?
Companies create diluted shares through various mechanisms. These allow employees or stakeholders to convert or exercise securities into common stock. The following are some of the usual ways to dilute shares:
- Stock Options. Companies often offer stock options to employees as part of their compensation. Employees can then buy shares at a predetermined price. These options increase the number of outstanding shares if exercised. It will dilute existing shareholder ownership.
- Convertible Bonds: Some companies issue bonds that are convertible to stock. The total number of shares will go up if bondholders opt to convert their bonds into shares. This dilutes the current shareholders.
- Warrants. This gives shareholders the right to buy stocks at a specific price within a certain period. These warrants increase the number of outstanding shares.
- Convertible Preferred Stock. Holders of preferred stock can sometimes convert their shares of common stock. This adds to the company’s share count and dilutes existing shares further.
What Do Diluted Shares Mean to Investors?
Diluted shares are crucial because they impact the ownership percentage and share value.
- Impact on Earnings Per Share (EPS)
Diluted shares have a major impact on the EPS. This is a critical metric investors use to check a company’s profitability. You can compute the EPS by dividing the net earnings by the number of shares outstanding. The EPS decreases when diluted shares are then added to the computation. This happens due to the spread of the earnings across a larger pool of shares.
Let’s consider a company that earns a million and has a million basic shares outstanding. The EPS would be $1. The total share count of 200,000 potential diluted shares is 1.2 million. The diluted EPS then becomes $0.83. This shows that potential dilution lowers each share value.
- Ownership Dilution
The ownership stake of existing shareholders becomes diluted when they issue more shares. Each investor’s percentage of company ownership goes down.
Let’s say you own 1,000 shares of a company with 100,000 shares outstanding. Then you own one percent of the company. If the company issues 50,000 new shares, your ownership stake drops to 0.67%. Your influence as a shareholder will go down too.
- Stock Price Pressure
Issuing more shares could put pressure on the stock price. When the number of shares increases, the market thinks the value is being divided. This can pull down the cost of each share. Unexpected or frequent dilution often decreases the value of a stakeholder’s investment.
Before You Go
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