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Diluted shares outstanding

Diluted Shares Outstanding

Diluted shares outstanding represent the total number of a company's common stock shares that would be in circulation if all exercisable financial instruments, such as stock options, convertible bonds, and warrants, were converted into common shares. This figure is a critical component in financial reporting and is used primarily in the calculation of diluted earnings per share (EPS), offering a more conservative view of a company's profitability on a per-share basis. The consideration of potential dilution is essential for investors and analysts in the broader field of corporate finance and valuation.

History and Origin

The concept of diluted shares outstanding gained prominence with the evolution of corporate finance and the increasing complexity of company capital structure. As companies began issuing various types of securities that could be converted into common stock, such as employee stock options and convertible debt, a need arose to present a more comprehensive picture of potential ownership and its impact on per-share metrics. The Financial Accounting Standards Board (FASB) formalized the requirements for calculating and presenting diluted earnings per share under U.S. Generally Accepted Accounting Principles (GAAP) in Accounting Standards Codification (ASC) Topic 260, "Earnings Per Share." This guidance mandates that public companies report both basic and diluted EPS to provide a more transparent view of potential dilution, which impacts shareholders. The Securities and Exchange Commission (SEC) also provides guidance on the proper tagging and reporting of earnings per share data in financial filings.4

Key Takeaways

  • Diluted shares outstanding account for all potential common shares that could be issued from convertible securities.
  • This figure is primarily used to calculate diluted earnings per share, providing a conservative measure of profitability.
  • The inclusion of dilutive securities increases the total share count, which typically lowers the earnings per share figure.
  • Understanding diluted shares outstanding helps investors assess the potential impact of future conversions on their ownership stake and per-share earnings.
  • Companies are required under GAAP to report diluted shares outstanding in their financial statements.

Formula and Calculation

The calculation of diluted shares outstanding involves starting with the weighted average shares outstanding and adding the incremental shares that would result from the assumed conversion or exercise of all dilutive securities. Two primary methods are used for calculating these incremental shares:

  1. Treasury Stock Method: Applied to options and warrants, this method assumes that the proceeds from the exercise of these instruments are used by the company to repurchase its own shares at the average market price during the period. Only the net increase in shares (shares issued minus shares repurchased) is considered dilutive.

    Incremental Shares (Treasury Stock Method)=Shares from Exercise−(Exercise ProceedsAverage Market Price)\text{Incremental Shares (Treasury Stock Method)} = \text{Shares from Exercise} - \left( \frac{\text{Exercise Proceeds}}{\text{Average Market Price}} \right)

  2. If-Converted Method: Applied to convertible bonds and preferred stock, this method assumes these securities are converted into common stock at the beginning of the period (or date of issuance, if later). Any interest expense (net of tax) or preferred dividends related to these securities are added back to net income in the diluted EPS calculation numerator.

    Incremental Shares (If-Converted Method)=Face Value of Convertible DebtConversion Price\text{Incremental Shares (If-Converted Method)} = \frac{\text{Face Value of Convertible Debt}}{\text{Conversion Price}}

The total diluted shares outstanding are the sum of the weighted average shares outstanding and the incremental dilutive shares calculated using these methods, provided they are actually dilutive (i.e., they reduce EPS or increase loss per share).

Interpreting the Diluted Shares Outstanding

Interpreting diluted shares outstanding provides a comprehensive perspective on a company's per-share financial metrics, particularly its diluted earnings per share. A higher number of diluted shares outstanding compared to basic shares outstanding indicates a significant potential for dilution from outstanding convertible securities. This means that if all these potential shares were to convert, the company's earnings would be spread over a larger number of shares, resulting in a lower diluted EPS.

Investors often use diluted EPS as a more conservative and realistic indicator of a company's profitability for current shareholders, considering all potential claims on future earnings. A substantial difference between basic and diluted shares outstanding can signal that a company has issued many employee stock options or convertible instruments, which could affect per-share values if converted.

Hypothetical Example

Consider XYZ Corp., which reported a net income of $10 million for the year.

  • It has 5 million weighted average shares outstanding.
  • It has 500,000 outstanding stock options with an exercise price of $20 per share. The average market price of XYZ Corp.'s stock during the year was $25 per share.
  • It also has $10 million in convertible bonds that can be converted into 200,000 shares of common stock. The bonds carry an annual interest expense of $500,000, and the company's tax rate is 20%.

Step 1: Calculate dilutive shares from stock options (Treasury Stock Method)

  • Proceeds from exercise: (500,000 \text{ shares} \times $20/\text{share} = $10,000,000)
  • Shares repurchased: ($10,000,000 / $25/\text{share} = 400,000 \text{ shares})
  • Incremental dilutive shares from options: (500,000 - 400,000 = 100,000 \text{ shares})

Step 2: Calculate dilutive shares from convertible bonds (If-Converted Method)

  • Incremental dilutive shares from bonds: 200,000 shares
  • Interest savings (net of tax) to add back to net income for diluted EPS: ($500,000 \times (1 - 0.20) = $400,000)

Step 3: Calculate Total Diluted Shares Outstanding

  • Weighted average shares outstanding: 5,000,000 shares
  • Add incremental shares from options: + 100,000 shares
  • Add incremental shares from convertible bonds: + 200,000 shares
  • Total diluted shares outstanding: 5,300,000 shares

In this example, XYZ Corp.'s diluted shares outstanding are 5.3 million. This figure would be used to calculate the diluted earnings per share by adjusting the net income ($10,000,000 + $400,000 = $10,400,000) and dividing by the diluted shares ($10,400,000 / 5,300,000 shares = $1.96 per share).

Practical Applications

Diluted shares outstanding are a fundamental metric in several areas of finance and investment analysis.

  • Investment Analysis: Analysts and investors heavily rely on diluted earnings per share (EPS), which incorporates diluted shares outstanding, to evaluate a company's profitability. It provides a more conservative and realistic view of what each share earns, especially for companies with complex capital structure and many outstanding convertible securities.
  • Company Valuation: When performing discounted cash flow (DCF) models or other valuation techniques on a per-share basis, using diluted shares outstanding can provide a more accurate representation of future per-share values.
  • Mergers and Acquisitions (M&A): During M&A activities, understanding the full extent of a target company's potential shares is crucial for determining the true cost of acquisition and the impact on the acquirer's per-share metrics.
  • Employee Compensation Planning: Companies offering stock options and other equity-linked compensation plans must understand their potential dilutive impact on existing shareholders and future earnings per share. For instance, public companies like Morningstar report significant amounts of share-based compensation, which contributes to potential dilution.3
  • Regulatory Compliance: Public companies are legally required to report diluted earnings per share under Generally Accepted Accounting Principles (GAAP), as mandated by the SEC. This ensures transparency in financial reporting. The guidance provided by the Federal Reserve and financial institutions regarding the convertible bond market also highlights the importance of these securities and their dilutive potential in the broader financial landscape.2

Limitations and Criticisms

While diluted shares outstanding provide a more comprehensive view of a company's potential share count, they come with certain limitations and criticisms. One common critique is that the calculation assumes the exercise or conversion of all dilutive securities, which may not always occur in practice. For instance, stock options with exercise prices significantly above the current market price may never be exercised if the stock price does not rise sufficiently. Similarly, convertible bonds may not be converted if the company's stock performance does not meet conversion thresholds or if interest rates make holding the debt more attractive.

Another limitation arises from the methods used for calculation. The treasury stock method, for example, assumes that proceeds from exercising options are used to repurchase shares, which might not be a company's actual use of funds. Furthermore, the calculation of diluted shares outstanding can be complex, involving numerous assumptions and estimations, particularly for companies with intricate capital structure and various types of dilutive instruments. Financial accounting guidance from bodies like EY outlines the complexities involved in adhering to ASC 260 for EPS calculations, including recent updates that impact how convertible instruments are treated.1 These complexities can sometimes lead to misunderstandings or misinterpretations of the true potential dilution.

Diluted Shares Outstanding vs. Basic Shares Outstanding

The primary distinction between diluted shares outstanding and basic shares outstanding lies in their scope. Basic shares outstanding, also known as weighted average shares outstanding, represent the actual number of common stock shares that are actively traded in the market during a reporting period, adjusted for any share issuances or repurchases. It offers a straightforward count of shares currently eligible for dividends and voting rights.

In contrast, diluted shares outstanding expand on this by including all potential common shares that could be created if existing convertible securities, such as stock options, warrants, convertible bonds, and preferred stock, were converted or exercised. The purpose of calculating diluted shares outstanding is to provide a "worst-case scenario" or a more conservative measure of a company's profitability per share, accounting for the potential dilution that could occur if these other securities were to become common shares. This leads to the calculation of diluted earnings per share, which is often lower than basic EPS.

FAQs

What types of securities contribute to diluted shares outstanding?

Securities that contribute to diluted shares outstanding typically include stock options, warrants, convertible bonds, and convertible preferred stock. These are financial instruments that can be converted into a company's common stock under specific conditions.

Why is diluted shares outstanding important for investors?

Diluted shares outstanding are crucial for investors because they provide a more realistic and conservative view of a company's profitability on a per-share basis, through diluted earnings per share. By accounting for potential dilution from other securities, it helps investors understand the maximum number of shares that could claim a portion of the company's earnings, thereby impacting the true value of each share.

Is it possible for diluted shares outstanding to be lower than basic shares outstanding?

No, diluted shares outstanding can never be lower than basic shares outstanding. The calculation of diluted shares outstanding always starts with the basic shares and then adds any additional shares that would result from the exercise or conversion of dilutive securities. If including these potential shares would result in an increase in earnings per share (an anti-dilutive effect), they are excluded from the calculation of diluted shares outstanding.

How do stock options affect diluted shares outstanding?

Stock options affect diluted shares outstanding through the treasury stock method. This method assumes that the proceeds a company receives from the exercise of options are used to buy back its own shares from the market. If the number of shares issued upon option exercise is greater than the number of shares that can be repurchased with the proceeds, the net difference adds to the diluted shares outstanding.

Do all companies report diluted shares outstanding?

Under Generally Accepted Accounting Principles (GAAP), public companies that have issued common stock that trades publicly or are in the process of filing to do so are required to present both basic and diluted earnings per share with equal prominence on their income statement. This means they must calculate and report diluted shares outstanding if they have potential common shares that could lead to dilution.