How do fully diluted shares affect earnings?
There are various factors like EPS (Earnings Per Share), Debt to Asset Ratio, Return on Equity etc., that impact the stock price of a company. Fully diluted share is another factor that impacts the EPS of an organisation and is crucial for investors to analyse the stock price in the stock market. This endows them with a better picture about what stocks to buy today or consider certain stocks to buy in future.
What is meant by fully diluted shares?
Fully diluted shares are the total number of company’s outstanding shares that can be traded in the open market after dilutive securities are performed or turned into shares. Such dilutive securities are employee stock options, warrants, convertible bonds, etc. Fully diluted shares involve company issued shares along with those shares that the investors can claim via the equity conversion option.
Investors usually analyse the fully diluted shares because it is an important factor that considerably impacts the company’s EPS. This is the company’s net income divided by the available shares in the market. This is the amount that a company earns for each distributed share. For instance, if the profit of the company is Rs. 2 lakh with outstanding shares of 20,000, EPS will equal Rs. 20.
How does a fully diluted share function?
A major goal behind considering fully diluted shares is their potential to impact the organisation’s EPS. As EPS is a popular metric to understand relative profitability and value of an organisation, investors consider fully diluted shares to be a necessity during the fundamental analysis process. Fundamental analysis is the method utilised by investors to recognise intrinsic stock value before they consider stocks to invest. Investors also consider the management quality, net asset value, and various other intangibles for understanding the value of the company and predict its stock price in the future.
Note that a common principle in the stock market today is that organisations holding higher EPS are positioned to perform better and witness an appreciation in future stock price. In case the company increases its EPS, stock price will enhance, and the investors will make good profits based on price appreciation. However, before analysing and calculating the company EPS, investors must look at the number of fully diluted shares to understand the relation with EPS.
In principle, fully diluted company shares hold an inverse relation with EPS. This means if the number of diluted company shares rises, EPS of the company falls and vice versa. Consider the above mentioned example wherein the net income was Rs. 2 lakh and outstanding shares were 20,000, which equated to Rs. 20 EPS. However, in case the outstanding shares/fully diluted company shares increase to become 40,000, this will lead to a fall in EPS to Rs. 5.
Thus, investors constantly look out for the number of diluted company shares because it can decrease or increase EPS. If EPS increases, it is a good indication because it portrays a potential increase in stock prices. But if the number of fully diluted company shares rises, EPS will decline, showing a potential decrease in stock price.
Fundamental analysis assists at arriving at the value of the stock. This allows investors to know if there is any safety margin in investment decision. However, there is zero way to conduct fundamental analysis without including EPS analysis. Now that you understand what fully diluted shares are and ways to calculate the fully diluted shares, utilise this knowledge to compute EPS of a company and invest as per the profit potential and value of that company.