How to Calculate Diluted Shares Outstanding
Updated: Jul 27, 2021
Diluted shares outstanding refers to the number of shares outstanding after employee stock options, restricted stock, and other convertibles are accounted for. Which should be included in the diluted share count and which should not? This article covers the process of determining diluted shares outstanding.
Employees are generally issued options that vest over time. When the employee exercises their options they have to pay the exercise price in order to receive the stock. Financial statements will often include a table like the one shown below which details the outstanding options and exercise prices.
Current stock price = $39.03
There two important columns are "Exercise Prices" and "Options Exercisable". There is a difference between the number of options issued and the number exercisable because not all options can be exercised right away after they are granted.
When the option is exercised the company receives cash in the amount of the strike price. For example, if the holder of the 126 options exercisable at $30.46 wanted to exercise their options they would need to pay 126*30.46 = 3837.96.
In order to calculate the dilutive impact of the options, we will use the treasury stock method. This method assumes that the proceeds the company receives when the options are exercised are used to purchase shares in the open market and reduce the number of shares outstanding.
Despite the fact that the company goes out and repurchases shares (hypothetically) the impact is still dilutive because investors don't exercise options unless they are in the money, meaning the stock price is greater than the exercise pric
In the example provided below, we assume that all in-the-money shares are exercised and the proceeds are used to repurchase shares. The difference between the number exercised and the number repurchased is the total dilution.
Under the treasury stock method, the total dilution is 100.25 shares.
A warrant is similar to an option issued by a company. A warrant grants the option to purchase shares at a certain price from the company. Warrant dilution is calculated using the treasury stock method, the same as options (described above).
3) Restricted Stock Units (RSU)
An RSU is a type of stock-based compensation where after a certain amount of time the employee is given shares (it may be settled in cash also). Unlike an option, the employee receives th RSU without having to pay any money or exercise anything like an option.
Generally, when an RSU vests it becomes part of basic shares outstanding. Therefore, the dilutive effects are 0. No modeling is necessary.
4) Convertible Preferred
There are two steps to test preferred share dilution.
1) Determine if they are in the money
Conversion price = redemption value / conversion rate
Conversion rate = how many shares they get for each preferred share.
If the conversion price is lower than the current stock price they are in the money.
2) Test for dilution using the if-converted method
To test for dilution find the EPS after the preferred shareholders convert their preferred shares to common shares. To do this add back the preferred dividends to net income attributable to common shareholders and add the new shares created in the conversion to basic shares outstanding. If EPS is less after conversion then the preferred shareholders get a larger fraction of net income after conversion and we assume they will convert.
5) Convertible Debt
Convertible debt follows the exact same process as convertible preferred shares:
1) Calculate the conversion price and determine if they are in or out of the money.
Conversion price = book value of debt / (conversion rate * # of bonds)
Conversion rate = how many shares they get for each bond
2) If they are in the money use the if-converted method to test for EPS dilution. If the conversion is EPS dilutive then assume conversion. Remember to make the appropriate tax adjustments.
In this case, the conversion reduced EPS from $1 to $.097 which means the conversion was EPS dilutive and we will assume conversion.
6) Dual Class Shares
Dual-class shares are usually differentiated by their voting power. The shares of each should entitle the owner to the same residual claim so the two can be treated the same when calculating diluted share outstanding.
Click here to subscribe.