1. What Is a Share Dilution?
2. Diluted Earnings Per Share (EPS)

Undiluted shares and diluted shares generally comprise the denominator of a public company's earnings per share. When a corporation goes public, there is an initial public offering. During this process, it will sell a number of undiluted common shares, earning a hefty return. The corporation's board of directors will decide how many outstanding shares to issue. These are then made available for trading through the stock market or a broker-dealer. The price of shares will depend on the earnings the corporation is reporting.

Any stocks that have potential to be contingent shares issued, warrants, or options that might be exercised are excluded. Stock or bonds that could be converted to common stock may also be excluded.

What Is a Share Dilution?

A conversion will dilute common stock's value since each share will be allocated a smaller portion of the total earnings amount. Other ways corporations can dilute common shares are:

  • Employee stock options
  • Restricted shares of common stock
  • Stock warrants

Whenever the number of shares increases, it will dilute the earnings that can be attached to each share. It will also require more votes to achieve the corporation's majority on important issues.

Sometimes, this difference can be extreme. An example is Microsoft. When they ended their fiscal year in June 2005, the basic earnings per share were $1.13. The diluted earnings per share were $1.12. You may think that is a minimal difference, but in previous years, it was more significant. In 2000, Microsoft had basic earnings per share of $0.91 versus $0.85, which represents a seven percent difference and a much bigger gap.

For the year 2000, 600 million additional shares factored into the diluted calculations. For the fiscal year 2002, the difference was around 300 million shares because the share price fell, which meant a less meaningful difference. When the share prices fall, there are fewer options “in the money.” This means they would have value if the shares were exercised since the exercise price is lower than the current stock price.

Out-of-the-money options do not count towards diluted shares as far as earnings per share are concerned. Shares that are fully diluted are the ones that are outstanding when all securities that can be converted (convertible bonds and stock options) are converted into common stock. Investors will be watching the fully diluted share value to see the amount of decrease in price and earnings per share as warrants and options are exercised, and bonds or preferred shares converted.

Another example of diluted versus undiluted shares is corporation XYZ with 100,000 outstanding shares that are valued at $10 per share. In addition, there are 25,000 convertible bonds and 50,000 options outstanding. You can assume each option gives the holder the right to purchase one share while each bond is convertible into two shares. If these bonds are converted and the options exercised, there will be 200,000 outstanding shares at a likely value of $5 per share.

Diluted Earnings Per Share (EPS)

A company that has complex capital strategies will report both their earnings per share and their diluted earnings per share. If you are attempting to calculate the DPS rather than just assuming the calculation on outstanding common stock options only, the investors are left to assume the numbers for the exercise of stock options and warrants, as well as the conversion of preferred stock and convertible bonds.

Then, you have to divide net income minus preferred stock dividends for a specific period of time by the number of common stock shares that would be outstanding provided all convertible securities were to be converted into common stock shares. Smart investors include dilution into the maximum they will pay for a corporation's common stock. They assume other investors are likely to immediately transfer all convertible securities into common stock when determining earnings per share.

This is not a likely scenario, but it allows an investor to formulate a standardized statistic that can be used to compare various corporations. Investors will then use this weakened earning figure to divide into the share price to calculate the share's fully diluted price to earnings ratio, known as the P/E ratio. Any shares that result in a high price to earnings ratio when compared to other similar shares are deemed expensive and could turn off budget-oriented investors until there's a rise in earnings, share prices fall, or dilution decreases.

One more factor that can reduce earnings per share is the amount of earnings that a business sets aside for dividends on preferred shares.

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