Updated July 19, 2023
Definition of Dilutive Securities
Dilutive securities are financial instruments like debentures, bonds, preference shares, etc. which have the option of conversion to common stock or normal securities at a certain point in time.
If the option is exercised, the earnings per share for existing shareholders will be reduced. As a result, it is said to as dilutive. If the company’s outstanding shares increase, it will automatically reduce the earnings per share.
Explanation
A company’s earnings per share are determined using a simple formula: total earnings divided by the number of outstanding shares. As a result, it is easy to see why dilutive instruments diminish earnings per share if the investor exercises the conversion option.
Because additional share capital reduces the existing shareholder’s ownership share or percentage, shareholders oppose dilution. This phenomenon impacts existing shareholders voting rights as well. It also has other impacts, which we will discuss in detail later.
Example of Dilutive Securities
Suppose a company had common stocks of $4 million, options & warrants of $0.5 million, preferred share stocks of $ 1 million, and convertible bonds of $0.5 million. Total earnings for the period were $8 million. Now the company’s total amounts to $2 million ($0.5 million + $1 million + $0.5 million) for options & warrants, preferred share stocks, and convertible bonds, respectively.
- Total Earnings for The Period: $8 million
- Basic EPS: $2 per share ($8 million ÷ $4 million)
- Diluted EPS: $1.33 per share, i.e., total earnings ÷ (common stock + dilutive securities).
Types of Dilutive Securities
Below are some of the main types.
1. Options and Warrants
The company issues options to its employees, granting them the opportunity to purchase company stocks at a specified price within a specific timeframe. Warrants, on the other hand, are similar to options in that they are distributed to employees but are not distributed to employees. Instead, they are made available to outside parties or the entire public.
2. Convertible Bonds
Convertible bonds are debt instruments with a fixed rate of return and an option of conversion to common stock at the end of the period or during a specific period.
3. Convertible Preferred Stocks
Convertible preference stocks are preference shares with a fixed rate of return similar to bonds and an option of conversion to common stock later. Preference stockholders are company shareholders and are preferred over common stockholders at liquidation.
Impact of Dilutive Securities
If investors choose to exercise the conversion option, it will lead to an increase in the number of outstanding shares within the company. As a result, the earnings per share (EPS) are likely to decrease.
- Investors consider earnings per share (EPS) as a significant metric for evaluating a company’s financial well-being.
- The income statement of a company provides the reported earnings per share. Publicly traded companies, which have an obligation to disclose EPS, typically present both EPS and diluted EPS figures.
- A huge difference between basic and diluted EPS can indicate more inclination of the company towards dilution in the near future, which is not a very attractive attribute for investors.
- Reduction or dilution in EPS concerns shareholders as their percentage claim over the company and voting rights diminish.
Dilutive Securities vs Anti-Dilutive Securities
Dilutive securities lead to a reduction in earnings per share when the investor chooses to exercise the option to convert their current deposits into common stock.
On the other hand, some securities leave an opposite impact on the earnings per share of an organization; when the investor exercises the conversion option, these securities will result in an increase in the company’s earnings per share. In anti-dilutive securities, a provision allows existing shareholders to buy additional shares when the investors exercise conversion options on dilutive securities.
Advantages
- It attracts investors with the option of converting to common stock later and thus helps raise finance, especially for start-up companies.
- Companies’ investment in dilutive securities and earnings per share allows investors to make investment decisions.
- Investment in dilutive securities is also one of the criteria to analyze the company’s financial health.
Conclusion
Dilutive securities are an important aspect of the company’s share capital as it helps in attracting investors who consider these securities a less risky option. The company’s dilutive earnings per share are always lower than basic earnings per share. But in the practical world, dilutive securities are more of a theoretical concept as the investors will only exercise the option if the purchase price generates profit.
Recommended Articles
This is a guide to Dilutive Securities. Here we discuss the definition and types of dilutive securities along with Examples and advantages. You may also have a look at the following articles to learn more –
