Earnings Dilution: What Investors Need to Know

Investing in a company is very much buying a piece of it. That includes being entitled to a piece of the profits that the company generates over time. However, the piece that's represented by the number of shares that an investor owns is often dynamic.

In a dramatically simplified example, assume that there are only 100 shares of stock for any given company. Owning one share would represent a 1% share of the company's profits. But if the company were to issue more shares, either to compensate employees or to raise capital, then there would be more total shares. If the company's total outstanding share count rose to 200, then your one share would now represent 0.5% of all shares.

Dilution definedOver time, the total number of outstanding shares of most companies change. There are many reasons why this may occur.

Companies sometimes like to repurchase shares in order to return capital to investors, which reduces total outstanding shares. Companies also frequently like to award shares to employees as a way to compensate them for performance, while simultaneously increasing talent retention. These awards typically take time to vest, which increases total outstanding shares.

Companies may also opt to issue and sell more shares as a way to raise equity capital, which also increases total outstanding shares. Dilution is the primary reason why stocks tend to fall if the company announces a secondary offering where it plans to raise capital by issuing and selling more stock.

These are the most common reasons why a company's total number of outstanding shares may change. When the total number of outstanding shares increases, an investor sees his or her overall percentage ownership in the company decline. This is the definition of earnings dilution.

There's more where that came fromBeyond any actual dilution that may occur over time, if the company's total number of outstanding shares increases, there's also potential dilution that can occur. This is because companies also issue securities and options that can result in additional shares being issued.

For example, one common form of employee equity compensation is options, which don't immediately result in new shares being issued, but will if the options are subsequently exercised. Other potentially dilutive securities include convertible bonds, warrants, debentures, or preferred stock.

What about diluted earnings per share?When companies report quarterly financial results, they typically include two different forms of earnings per share: basic earnings per share, and diluted earnings per share. Basic earnings per share is derived by dividing net income by the current total number of outstanding shares. Diluted earnings per share is what you get if you divide net income by the total number of outstanding shares including if all potentially dilutive securities are exercised.

In the vast majority of cases, convertible securities will result in a higher share count and a lower diluted EPS. In rare instances, convertible securities can lead to a higher diluted EPS, but these types of securities are specifically excluded when a company calculates the diluted EPS that it reports. In this sense, diluted EPS is the more conservative metric to follow, even if it's unrealistic that all potentially dilutive securities will all be exercised in the near term.

The article Earnings Dilution: What Investors Need to Know originally appeared on Fool.com.

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