What are Diluted Shares?
A diluted share generally is bad news for current shareholders, and is used to refer to the loss of value accruing to each existing share when the company issues new shares of stock. Because each share represents a small but equal portion of the company’s equity, the addition of more shares reduces each individual share’s equity and, consequently, its value. Roughly, the value of an individual share is calculated by dividing the company’s net value by the total number of shares of stock available; while other factors apply, this serves as a general estimate of share value.
The formula for calculating value per share is expressed thusly:
• Net value of company / total outstanding shares of stock
If the total number of outstanding shares increases, the value per share is decreased proportionately. For example, a company that is valued at $100,000 and has issued 50,000 shares of common stock has a value per share of $2.00. If the company then issues an additional 50,000 shares of common stock to the public, this dilutes the value of the previously existing shares and creates a value per diluted share of $1.00, effectively creating a loss in value of $1.00 per existing share and reducing the equity held by existing shareholders.
Some companies elect to issue stock options or other convertible securities (including certain types of preferred shares of stock). While these do not immediately dilute the value of existing shares, they have the potential to do so in the future; as a result, most companies provide their shareholders with a total fully diluted share amount, indicating the number of shares outstanding if all option holders and preferred shareholders exercised their options to purchase common stock. This information provides a measure of security for investors; by assessing the possible risk that these options will be exercised, shareholders can protect themselves against fluctuations in the value of shares held.
Since diluted shares produce lower earnings per share, companies also generally release information on the diluted earnings per share as a financial indicator of profitability. By deriving an estimate of earnings per diluted share and then comparing this with the announced earnings per share, analysts and investors can assess the risk of a major dilution of existing shares and a consequent devaluation of current share prices.
In some cases, companies make a stock offering in order to finance an expansion into the marketplace or an innovative new manufacturing process. While this also results in diluted shares and lower earnings per diluted share, if the effects of the expansion or innovation produce a significantly higher net value for the company, the diluted per share value may actually be higher than the initial value before dilution. This increase in overall value can present a compelling reason for shareholders to approve an additional stock offering in spite of the diluting effect on existing shares; the potential for future earnings may outweigh the short-term loss in value and earnings per diluted share.