Diluted Vs. Undiluted Shares

A corporation goes public through an initial public offering. In the process, it sells a fixed number of pristine, undiluted common stock shares and reaps a boatload of cash. The board of directors decides on the outstanding number of shares; these are available for trading on the secondary markets (on stock exchanges and through broker-dealers). Share price depends in part on the corporation’s earnings. Investors and analysts evaluate a stock by calculating earnings per share of common stock -- the net income for the quarter or year available to common stockholders divided by the period’s average number of common shares outstanding.

A corporation might not be satisfied with a single boatload of investor money. To get more, it can issue preferred stock and corporate bonds. To entice investors, the corporation can make these securities convertible, which means that under certain circumstances, investors can exchange them for new shares of common stock. Conversions dilute the value of existing common stock, since each share now owns a smaller slice of the earning pie, and it takes more votes to form a majority on corporate issues. Corporations can also dilute common shares by issuing stock warrants, employee stock options and restricted shares of common stock.

Savvy investors factor dilution into the price they are willing to pay for a company’s common stock. They calculate fully diluted earnings per share (EPS) by assuming investors will immediately exchange all convertible securities for common stock. While this assumption is not likely to materialize, the calculation allows investors to form a standard statistic they can use to compare different corporations. Investors then divide this watered-down earning figure into share price to computer the share’s fully diluted price/earnings ratio (P/E ratio). The result is an inflated P/E ratio. Shares with a high P/E ratio relative to those of competitors' shares are “expensive” and might repel value-oriented investors until earnings increase, dilution decreases or share prices fall.

Another factor that reduces common stock EPS is the amount of earnings the corporation devotes to dividends on preferred shares. Since these earnings are not available to common stockholders, it further reduces EPS and raises the P/E ratio. Both results apply downward pressure on common stock prices, which might raise the hackles of investors who own common shares. Preferred stock dividends leave less money available to pay dividends on common stock, another source of common stockholder discontent. Despite dilution, if enough common shareholders sour on their treatment at the hands of the board of directors, they can vote the scoundrels out of office.