How Do Fully Diluted Shares Affect Earnings?

Basic outstanding shares and fully diluted shares measure the quantity of stock issued by a company using different methodologies. Outstanding shares are the company's stock that have been authorized and issued, representing ownership of the company by investors or institutions holding those shares. Fully diluted shares include all those equities plus additional shares if all convertible securities of a company were exercised. 

Fully diluted shares are the total number of shares that would be outstanding if all possible sources of conversion, such as convertible bonds and stock options, are exercised. This number of shares is important for a company’s earnings per share (EPS) calculation, because using fully diluted shares increases the number of shares used in the calculation, reducing the dollars earned per share of common stock.

EPS is a calculation of the dollar amount of earnings a public company generates per share of common stock. Analysts consider this ratio to be a key indicator of company value, also offering an important metric for shareholders.

EPS is defined as (net income – preferred dividends) / (weighted average common shares outstanding). Any earnings paid to preferred shareholders as a cash dividend are subtracted from net income, because the ratio applies only to common shareholders. Weighted average common shares is the (beginning period balance + ending period balance) / 2. If a business can generate more earnings per common share, the company is considered to be more valuable and the share price may increase.

Assume, for example, that ABC Corporation generates $10 million in net income and pays all preferred shareholders a total of $2 million in dividends, so that the net income available to all common shareholders is $8 million. If the firm’s weighted average common shares outstanding total 1 million, the EPS is $8 per share. The $8 EPS is considered "basic EPS", because the total is not adjusted for dilution.

Several types of securities can be converted into common stock, including a convertible bond, convertible preferred stock, stock options, rights and warrants. Full dilution assumes every security that can be converted into common shares is converted, lowering the earnings available per share of common stock. 

For example, assume that ABC issues 100,000 shares in stock options to company executives to reward them for reaching a profit goal. The firm also has a convertible bond outstanding that allows the bondholders to convert into a total of 200,000 shares of common stock, and ABC has convertible preferred stock outstanding, and those shares can be converted into 200,000 shares of common stock.

Full dilution assumes these 500,000 additional common stock shares are issued, which increases the shares outstanding to 1.5 million. Using the $8 million in earnings in the prior example, fully diluted EPS is ($8 million / 1.5 million shares), or $5.33 per share, which is lower than the basic EPS of $8 per share.