Fully Diluted Shares

There are numerous factors such as Earnings Per Share, Return on Equity, Debt to Asset Ratio, etc., that affect a company’s stock price. If you do not know how to evaluate these factors and their consequences you are speculating, which can turn sideways in a matter of hours.

Furthermore, another factor called Fully Diluted Shares influences the Earnings Per Share of a company and is vital for investors to predict the stock price. In IIFL’s quest to infuse financial literacy, this blog will help you understand the fully diluted shares definition and how to use the knowledge to make better-investing decisions. Let’s start with the basics.

What are Shares?

In simple words, a share indicates a unit of ownership of a particular company. If you own shares of a company, it implies that you, as an investor, own a percentage of the issuing company. These shares are listed on the stock exchanges through an Initial Public Offering, and investors can buy and sell them based on their current price.

If you buy the shares of a company, you become the owner of the company in the proportion of the percentage of the purchased shares. From the day you buy the shares, you are a shareholder and entitled to receive a portion of the profit of the company. This amount is called the dividend, and the company declares it as per its financial performance. The shareholders can sell these shares anytime they want to another investor who would then become the shareholder.

What are Fully Diluted Shares?

Fully diluted shares are defined as the total number of shares of a company that is outstanding and can be traded by investors on the open market after all the dilutive securities are exercised or converted into shares. These dilutive securities can be employee stock options, warrants, options, convertible bonds, etc. Fully diluted shares include currently issued shares by a company along with those shares that investors can claim through the option of equity conversion.

Investors consider the understanding and analysis of the fully diluted shares as it is a vital factor that significantly affects a company’s Earnings Per Share (EPS). It is the net income of the company divided by available shares in the market. It is the amount a company earns for every distributed share of its company. For example, if a company's profit (Net Income minus preferred dividends) is Rs 2,00,000 and at the end, common outstanding shares are 20,000, its EPS will be Rs 20.

Investors need the number of fully diluted shares to calculate a company’s Earnings Per Share (EPS) to increase the shared basis and reduce the rupee earned per share of a company’s common stock.

How do Fully Diluted Shares Work?

The main objective behind factoring in fully diluted shares is their capability to affect a company’s Earnings Per Share. As Earnings Per Share is a widely known metric to understand the relative value and profitability of a company, investors consider fully diluted shares as a necessity in the process of Fundamental Analysis.

Fundamental analysis is a method used by investors to identify the intrinsic value of a stock. Investors look at net asset value, management quality, and other intangibles to understand the company’s value and predict its future stock price.

It is a common principle in the stock market that companies with higher Earnings Per Share are better positioned to do well and appreciate the stock price in the future. If a company can increase its EPS, the stock price will increase and investors will make profits based on the price appreciation. However, before calculating and analyzing the EPS of a company, investors look toward the number of fully diluted shares for its relationship with the EPS.

In principle, the fully diluted shares of a company have an inverse relationship with its Earnings Per Share. It means that if the number of fully diluted shares increases, the EPS of the company decreases and vice versa.

Considering the above example, where the outstanding shares were 20,000 and the net income was Rs 2,00,000, the EPS will be Rs 20. However, if the outstanding shares or fully diluted shares increase and become 40,000, it will result in the EPS falling to Rs 5.

Thus, investors watch out for the number of fully diluted shares as it can increase or decrease the EPS. If there is an increase in the EPS, it can be a good sign as it indicates a potential rise in the stock price. However, if the number of fully diluted shares increases, the EPS will fall, indicating a potential fall in the stock price.

How to calculate Fully Diluted Shares?

Here are the steps you should undertake to calculate the fully diluted shares of any company:

• Stock Options: You need to find out the total number of stock options that the company’s employees have. Only those employees who are with the company currently can exercise the stock options. You also have to factor in the stock options given to outside investors. Once you know the total number, you will know the number of shares these employees or investors can buy using these stock options, which can add to the fully diluted shares at the time of exercising.
• Warrants: These are similar to an options contract, where the holder has the right to buy the company shares at a specific price in the future. You need to find the number of warrants and then multiply the number of shares the holders can convert each warrant into. This will allow you to determine the number of outstanding shares in case the warrants are exercised.
• Convertible Bonds: Bonds are debt instruments, which implies that they work on the principle of loans, where a company issues bonds to borrow money from the lender. In the case of convertible bonds, the bondholders have the option to convert them into the shares of the company, adding to the fully diluted shares. Therefore, you need to determine the total number of convertible bonds issued by the company.
• The Result: Once you have calculated the number of the above three factors, you will know the number that can add to the current outstanding shares. Add this to the company’s current outstanding shares, and you will have the number of fully diluted shares of a company. You can, then, effectively calculate the EPS of the company and understand its profitability.

Final Words

Fundamental analysis helps arrive at a likely value for the stock based on future cash flows. It enables investors to see if there is a margin of safety in the investment decision. However, there is no other way to perform fundamental analysis without adding the analysis of EPS. Now that you know the fully diluted shares definition and how to calculate fully diluted shares, use the knowledge to calculate the EPS of a company and invest according to a company’s value and profit potential.