Having looked at how it is we can calculate basic earnings per share, we can now start to look at how it is that the concepts of dilution, and anti-dilution impact the ability of a company to pay out returns to its individual shareholders. Specifically, by keeping track of how it is that options, warrants, and convertible bonds all change the way in which an investor looks at a company’s earnings per share.
The first step to examining dilution is to determine what sort of securities the company has currently outstanding, and how it is that they impact the capital structure. For example, if a company’s outstanding package of convertible bonds were all changed into equity securities, we’d see that the net income of the company would increase by the amount of interest that would have otherwise been paid out to the common shareholders (adjusted for debt), and that the amount of equity outstanding would also increase by the amount of new shares that are issued by the amount of the conversion.
In this situation, we can see how it is that the issuance of new debt from a bond conversion dilutes out other shareholders, but balances itself by the reduced interest payments. Overall, we want to make a note of any convertible bonds, warrants, or stock options that are outstanding on the company’s shares.
The second step to examining diluted earnings per share is to determine whether or not the listed securities (those that are potentially dilutive) would likely be executed. For example, if a stock is currently trading at $50/share, an option with an exercise price of $65 is not likely to be exercised because it would mean for an immediate loss of $15/share for the investor. However, if the exercise price were $30/share, the investor is very likely to execute the option and convert it into shares, because they stand to earn a profit of $20/share. In this step, we want to add up the total number of shares that are likely to exist by the end of the year as a result of execution. These extra shares that are added to the equity outstanding will dilute out current investors.
The final step to calculating diluted earnings per share it is to re-calculate the change in equity outstanding, with respect to any differences in incomes that would result from the share conversions themselves. We then compare this final diluted metric to the basic earnings per share value that is calculated without potentially dilutive securities. If the diluted earnings per share metric is lower than the basic counter-part, it is safe to conclude that the investment carries dilution risk.
However, if the diluted metric is higher than the basic, the execution of these shares would be anti-dilutive, and would increase shareholder value (ie. say if an investor were to execute options that were not yet in the money, this would drive up the price of share, because the investor is buying shares at above market price).