Definition
Dilutive Securities are financial instruments like options, convertible bonds, or warrants that can increase the total number of a company’s outstanding shares if exercised or converted. When these securities are converted, it can result in the decrease of earnings per share (EPS) and dilute the ownership percentage of existing shareholders. However, they potentially result in additional capital for the company.
Key Takeaways
- Dilutive Securities refer to financial instruments like options, warrants, convertible securities which can be converted into equity or common shares. On conversion, these increase the total number of outstanding shares in the company.
- The conversion of dilutive securities often leads to a reduction in earnings per share (EPS) or dilution, as the earnings get divided among a higher number of shares. This can potentially lead to a decrease in the stock price.
- Dilutive securities have an impact on the calculation of a company’s diluted earnings per share (EPS). They are essential to consider in financial analysis, as they provide a complete picture of a company’s financial health and potential future equity state.
Importance
Dilutive Securities are crucial in finance since they can potentially alter a company’s earnings per share (EPS) in the future.
These are securities like stock options, convertible bonds, or convertible preferred shares, which can be converted into common shares.
If converted, they increase the total number of shares outstanding, thereby diluting the EPS.
This is an important consideration for investors as it could potentially decrease the value of their holdings.
The concept of dilution helps investors assess the future earning potential and relative ownership of a company, influencing the decisions of potential investors and current shareholders.
Explanation
Dilutive securities are financial instruments like options, convertible bonds, or warrants that can increase the number of outstanding shares of a company, thereby reducing, or ‘diluting’, the earnings per share (EPS) and ownership interest for existing shareholders. The purpose of issuing dilutive securities isn’t to intentionally dilute the EPS but to generate capital.
They serve as an alternative to direct equity financing, allowing companies to raise funds while offering potential upside to investors in the form of equity ownership if the company performs well. The main purpose of dilutive securities is to fuel corporate expansion, finance debt repayment, or fund new projects within the company.
When these securities convert into common stock, the capital raised helps back the company’s growth. However, this conversion affects existing shareholders as it dilutes their ownership percentage and can potentially dilute company earnings as well.
Despite this, if the dilution leads to greater company growth and earnings in the long run, it can offset the initial negative effects and build shareholder value over time. Hence, dilutive securities are a strategic financial instrument used by companies aiming for growth.
Examples of Dilutive Securities
Stock Options: An example of dilutive securities can be seen in many tech companies that often give their employees stock options as part of their compensation. For instance, let’s take the example of Twitter. When it went public in 2013, it had around 80 million stock options for its employees. If all those stock options were exercised, the total equity share capital of the company would increase, diluting the ownership percentage of existing shareholders.
Convertible Bonds: In 2014, electric car company Tesla issued $2 billion in convertible bonds. These bonds could be converted into shares of Tesla stock at a future date if certain conditions were met. If the bondholders decided to convert their bonds into shares, the total number of outstanding shares in Tesla would increase. This would dilute the value of existing shares, making each share worth less than before.
Warrants: Airline companies sometimes issue warrants to raise capital. For example, during the financial crisis in 2008, many airlines like United Airlines and American Airlines issued warrants to investors as a way to raise funds. These warrants gave the investors the right to purchase shares in the company at a future date at a predetermined price. If these warrants were exercised, it would increase the total number of shares outstanding, thus diluting the value of existing shares.
FAQs about Dilutive Securities
What are Dilutive Securities?
Dilutive securities are financial instruments like options, warrants, convertible bonds, or convertible preferred stock, that can increase the number of outstanding shares in a company. If these instruments are converted into shares, they can potentially dilute the earnings per share (EPS), thereby reducing the value of the individual shares.
How do Dilutive Securities impact a company’s Earnings Per Share (EPS)?
When dilutive securities are converted into common shares, the number of outstanding shares of a company increases. When the number of shares increases without a corresponding increase in earnings, it reduces the EPS. This often leads to a decrease in the value of individual shares because EPS is a key measure of a company’s profitability.
What is a Non-Dilutive Security?
A non-dilutive security is a type of financial instrument that does not increase the number of outstanding shares when it’s exercised or converted. Non-dilutive securities such as bonds, preferred stocks, or options that are out of the money, do not dilute earnings per share (EPS) and, thus, do not decrease the value of individual shares.
What are the implications of Dilutive Securities for investors?
For investors, dilutive securities may decrease the value of their holdings as higher number of outstanding shares can reduce the EPS, assuming that earnings remain constant. However, dilutive securities such as convertible bonds or warrants can also serve as a potential investment opportunity as they can be converted into shares often at a lower cost compared to buying the shares directly from the market.
How can companies manage Dilutive Securities?
Companies can strategically manage dilutive securities by considering the potential benefits and drawbacks. They may issue dilutive securities to generate funds while minimizing the immediate impact on its EPS. However, they also have to consider its future impact on the EPS and stock price when these securities are converted into common shares. They can also use mechanisms like buy back programs to reduce the number of outstanding shares and hence manage the dilution.
Related Entrepreneurship Terms
- Convertible Bonds
- Employee Stock Options
- Warrants
- Preferred Shares
- Convertible Preferred Stock
Sources for More Information
- Investopedia: They have abundant resources on a wide variety of finance and investing terms, including dilutive securities.
- Corporate Finance Institute: They provide detailed courses, articles, and resources on corporate finance which includes information on dilutive securities.
- The Balance: A personal finance website with a broad library of articles about investing, including pieces that explain the concept of dilutive securities.
- Fidelity: An investment firm that offers explanations of many finance terms, including dilutive securities, on their website.
