Earnings per share is defined as (net income)/ (outstanding shares of common stock). When most people say “earnings per share”, they’re referring to earnings per share of common stock.
Issued, authorized and outstanding shares (and also treasury stock)
I’ll take a detour and explain an important concept related to common stock. Please note the difference between these three terms:
· Issued shares: Issued refers to shares sold to the public.
· Outstanding shares: Shares held (owned) by the public. Wait- why would the issued shares differ from the outstanding shares? Once they’re sold to the public, don’t they stay in the public hands? Not always the case- read on…
· Treasury shares: Shares that were issued and repurchased by the issuing company. (Issued shares) – (Treasury shares) = Outstanding shares.
· Authorized Shares: The maximum number of shares a company is allowed to issue. That amount is normally stated in the company’s corporate charter. In other words, authorized shares are determined when the company is formed.
Dilutive earnings per share
Take a look at the formula for earnings per share (EPS) above. You’ll note that the denominator is common shares outstanding. So, if you earned $5 and had 100 shares outstanding, your EPS would be ($5/100) = $.05 per share.
Now, consider dilution. When you mix Kool-Aid with water, the drink mix is diluted- thins out. Now, apply that concept to EPS. If total earnings stay the same ($5) and common shares outstanding increase, your EPS will go down. If you earned $5 and had 200 shares outstanding, your EPS would be ($5/100) = $.025 per share. The larger denominator (common shares) generates a smaller EPS.
Securities that can cause dilution
There are several types of securities that allow the holder to convert the security into common stock. When you consider dilution, you assume that all securities that can be converted into common stock are converted. That view allows you to see the maximum number of common shares investors could potentially own. Here are four examples:
1. Call options on stock: An option is a contract. A call option buyer pays a fee (called a premium) to own a right. The buyer has the right to buy a certain number of shares of common stock- at a certain price, for a certain period of time. If the option buyer exercises his or her right, they purchase more shares of common stock. Stock options are often issued to employees as an incentive to stay with a company and help it grow.
2. Warrant: A warrant also allows the owner to buy stock. A warrant is usually issued with a bond. The warrant make the bond more attractive to a potential buyer. If an investor buys the bond and the warrant, they earn interest on the bond- and also can use the warrant to buy common stock. So, they can participate in the company’s debt and equity.
3. Convertible Preferred Stock: Preferred stock is slightly different from common stock. Stock is “preferred”, because preferred shares are paid a dividend before common shareholders. If the company liquidates, preferred shareholders are “in line” ahead of common shareholders. If there are assets left after liquidation, a preferred shareholder’s claim on those assets comes before common shareholders. Convertible preferred stock allows the owner to convert from preferred stock to common stock shares.
4. Convertible Bond: A convertible bond allows the owner to convert from a bond to shares of common stock shares. The terms of the conversion (ie- how many shares, price paid per share) are stated on the bond certificate. In that way, it’s clear to the owner how the bond can be converted.
All four of these securities can be converted into common stock. So, all four are considered to be dilutive securities. If outstanding shares of common stock increase- and total earnings stay the same- earnings per share will decline.
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