Legal Definitions - fully diluted earnings per share

Fully diluted earnings per share is a financial measurement that calculates a company's profit for each share of its common stock, taking into account all outstanding convertible securities as if they had already been converted into common shares. This metric provides a more conservative or "worst-case" view of a company's profitability per share because it assumes the maximum possible number of shares are outstanding. It considers the potential impact of items like employee stock options, warrants, convertible bonds, and convertible preferred stock, which could increase the total number of common shares and thus dilute the earnings attributable to each existing share.

Understanding fully diluted earnings per share helps investors assess the potential reduction in their ownership stake and per-share earnings if all these convertible securities were to be exercised or converted into common stock.

• Example 1: Tech Startup with Employee Stock Options

  Imagine a rapidly growing technology startup that offers a substantial number of stock options to its employees as part of their compensation. These options give employees the right to purchase company stock at a set price in the future. When the startup calculates its fully diluted earnings per share, it must assume that all these employee stock options have been exercised and converted into common shares. This hypothetical increase in the total number of shares outstanding would be used in the calculation, potentially lowering the earnings per share figure compared to a basic calculation. This provides potential investors with a realistic picture of what their share of earnings would be if all employees exercised their options, reflecting the full potential impact of these outstanding options on per-share profitability.

• Example 2: Manufacturing Company with Convertible Bonds

  Consider a manufacturing company that has issued convertible bonds to raise capital for a new factory. These bonds function like regular debt, paying interest, but they also give bondholders the option to convert them into a specific number of common shares at a later date. To determine its fully diluted earnings per share, the company calculates its earnings as if all these convertible bonds have already been exchanged for common stock. This hypothetical conversion adds more shares to the total outstanding, which could reduce the earnings attributed to each individual share. This metric is crucial for investors because it reveals the potential impact on their ownership stake and per-share earnings if bondholders decide to convert their debt into equity.

• Example 3: Investor Evaluating a Company with Convertible Preferred Stock

  An individual investor is researching a utility company and notices it has issued convertible preferred stock. This type of preferred stock can be exchanged for a specific number of common shares under certain conditions. When the investor reviews the utility company's financial statements, they would pay close attention to the fully diluted earnings per share. This figure would show the company's profitability per share assuming all the convertible preferred stock has been converted into common shares. This helps the investor understand the potential dilution of their ownership and the potential reduction in earnings per share if those preferred shares were to convert, providing a more conservative and complete view of the company's per-share profitability.