Basic vs. Diluted Shares

While basic shares outstanding and diluted shares outstanding might seem like minor details, understanding the difference between these two figures is crucial for accurately assessing a company's profitability and true earnings per share (EPS).

Let's break down what each term means and why the distinction is so important.

Basic Shares Outstanding: The Straightforward Count

Basic shares outstanding represent the simplest calculation of a company's shares. It's the number of common shares that have been issued by the company and are currently held by investors.

It's a direct count of all the common stock that's currently in circulation.

Diluted Shares Outstanding: The What If Scenario

Diluted shares outstanding, on the other hand, take a more conservative and forward-looking approach. This figure includes all basic shares outstanding plus the shares that could be created if certain convertible securities or stock options were exercised.

Examples of convertible securities:

• Stock Options: These give employees or others the right to buy a company's stock at a predetermined price. If the stock price rises above that price (in-the-money), it becomes profitable to exercise these options, thus creating new shares.
• Convertible Bonds: These are bonds that can be converted into a fixed number of common shares at the investor's option.
• Convertible Preferred Stock: Similar to convertible bonds, this is preferred stock that can be exchanged for common shares.
• Warrants: These are long-term options that give the holder the right to purchase shares at a specific price, often issued alongside other securities.

The key here is potential dilution. Even if these options or convertible securities haven't been exercised yet, accounting standards require companies to consider their potential impact on the total share count.

This is because exercising them would increase the number of shares outstanding, thereby diluting the ownership stake of existing shareholders and reducing EPS.

Why Does the Difference Matter? The Impact on EPS

The primary reason investors need to understand both basic and diluted shares is their direct impact on Earnings Per Share (EPS).

• Basic EPS: Calculated as Net Income / Basic Shares Outstanding. This gives you a straightforward measure of how much profit the company generated per existing share.
• Diluted EPS: Calculated as Net Income / Diluted Shares Outstanding. This is a more conservative and realistic measure because it accounts for the potential increase in the number of shares.

Here's why Diluted EPS is often the more crucial metric for investors:

• A More Realistic View of Profitability: Diluted EPS provides a clearer picture of what each share would earn if all potential sources of new shares were realized. A significant difference between basic and diluted EPS can signal that future earnings per share might be lower than what the basic EPS initially suggests.
• Assessing Future Value: When you're valuing a company or comparing it to competitors, using diluted EPS helps you avoid overestimating its per-share earnings potential. If a company has a lot of outstanding options or convertible securities, its future EPS might be significantly lower than its current basic EPS.
• Understanding Management Incentives: Companies often use stock options as part of employee compensation. A large number of unexercised options can indicate that management and employees have a strong incentive for the stock price to rise, but it also means potential dilution for existing shareholders.

Practical Application for Investors

When you're analyzing a company's financial statements, always look at both basic and diluted shares outstanding and, more importantly, always pay close attention to diluted EPS.

• Check the difference: Is there a significant gap between basic and diluted EPS? If so, investigate the reasons for the potential dilution. It could be a normal part of compensation or a sign of substantial convertible debt that could eventually flood the market with new shares.
• Compare over time: How have basic and diluted shares changed over several quarters or years? An increasing trend in the gap could indicate more potential dilution on the horizon.
• Use diluted EPS for valuation: When calculating metrics like the Price-to-Earnings (P/E) ratio, use diluted EPS for a more conservative valuation.

The Bottom Line

While basic shares give you a current snapshot, diluted shares provide a crucial what if scenario that is essential for a comprehensive understanding of a company's true earnings power.

By focusing on diluted EPS, you'll be making more informed investment decisions, safeguarding your portfolio against the potential impact of future share dilution.