When you dilute a drink with water, you lessen its flavor. Share dilution in a corporation is similar. Dilution increases the number of shares outstanding, which reduces earnings per share and each shareholder’s percentage ownership. Employee stock options are one type of security that can potentially dilute a company’s shares. An option gives its holder the right to buy stock from a company at a predetermined price. You can calculate a company’s diluted shares to see the number of shares that would be outstanding if all employee stock options were exercised.
Download a company’s Form 10-K annual report from the investor relations section of its website or from the U.S. Securities and Exchange Commission’s online EDGAR database.
Locate the company’s balance sheet in the annual report. Identify the number of common shares the company has outstanding in the stockholders’ equity section of the balance sheet. For example, assume a company has 20 million shares outstanding.
Find the number of employee stock options it has outstanding and the exercise, or strike, price per share in the footnotes to the financial statements. In this example, assume a company has 1 million options outstanding with an exercise price of $10.
Subtract the exercise price from the company’s current stock price. In this example, assume the current stock price is $17. Subtract $10 from $17 to get $7.
Divide your result by the current stock price. In this example, divide $7 by $17 to get 0.411765.
Multiply your result by the number of options outstanding. In this example, multiply 0.411765 by 1 million to get 411,765.
Add your result to the number of common shares outstanding to calculate the diluted shares. Concluding the example, add 411,765 to 20 million to get 20,411,765 diluted shares.
- This calculation uses the treasury stock method to calculate diluted shares, the same method generally accepted accounting principles, or GAAP, require a company to use. A company with employee stock options and other dilutive securities uses this diluted share figure to calculate and report its diluted earnings per share, or EPS, on its income statement.
- If the current stock price is less than the options’ exercise price, employee stock options would have no dilutive effect on shares because employees wouldn’t exercise an option for more than the stock is worth.