Diluted Shares Outstanding

Diluted shares outstanding vs. Fully diluted shares

  • Shares outstanding: actual number of shares of common stock that have been issued as of the current date
  • Fully diluted shares: number of shares that would be outstanding if all "in the money" options were exercised
  • Diluted shares = basic shares + dilutive securities
    • Dilutive securities include options, restricted stock, and other securities that can become common stock
Types of dilutive securities:
  1. Stock options: issued to pay and motivate employees; gives employees the option to purchase common stock at a given price over an extended period of time
    • Check for in the money / out the money
  2. Restricted Stock (RSU): another form of stock-based compensation. Employees get shares subject to vesting. Unlike options, there is no exercise price, and employees receive the stock free and clear upon vesting
    • Don't have to check for in the money / out the money
  3. Convertible bonds: can be converted into common shares upon a certain strike price. Conversion gives investors benefit of defined interest payments and upside of equity
  4. Convertible preferred is similar to convertible debt. Provides all the benefits of preferred stock (dividends, priority of payments) with a conversion feature that provides upside of equity
In-the-money and Exercisable Options:
  • Each option has an exercise (strike) price, which the owner must pay to the company to exercise the option
  • Only include "in the money" options in the share count because these are the options that have the potential to dilute the company's shareholder base
  • To keep employees around, companies impose vesting restrictions on options; so a 10,000 option grant might vest evenly over 3 years
  • Use only options exercisable in a standalone DCF
  • But if building a DCF to value a target company in M&A analysis, use outstanding or "vested and expected to vest" options instead of exercisable as unvested options often vest upon a change of control
How do you calculate the number of fully diluted shares?
  • Treasury stock method
    • This method finds the number of current shares outstanding, adding the number of options and warrants that are currently "in the money," then subtracting the number of shares that could be repurchased using the proceeds from exercising the options and warrants
    • Way of estimating the effects of employee stock options as well as convertible and preferred stock to calculate number of fully diluted shares outstanding
    • Mainly used to estimate diluted EPS numbers
  1. Begin with the company's common shares outstanding. E.g. assume a company has 1,000,000 shares outstanding
  2. Then find the company's options chart. The options that will be exercised are those with a weighted average exercise price below the current market price. Assume there are 100,000 shares with exercise price of $5 and the stock is selling for $10 currently. 
  3. This means that 100,000 new shares of the stock will be issued, and the company will profit $500,000 from sale of those shares. Now there will be 1,100,000 shares
  4. That $500,000 profit will then be used to repurchase shares in the open market at $10 per share
  5. The company will repurchase 50,000 shares, meaning there will be 1,050,000 shares after the exercise of options
Note: only exercise options that are in the money


Interview Questions:

If a company has 1,000 shares outstanding at $5 per share and also has 100 options outstanding at an exercise price of $2 per share, what is the company’s fully diluted Equity Value?
  • 1000 + 100 = 1100 shares
  • 100 * 2 = $200 profit
  • $200 / 5 = 40 shares bought back
  • 1100 - 40 = 1060 shares outstanding
  • 1060 * 5 = $5300 Eq V
The company has 100 shares, traded at $10, and 10 options exercisable price of $12 per share, what is the fully diluted shares outstanding?
  • 100, because it is out the money

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