In this episode of What’s New at CFI on FinPod, we dive into the complexities of calculating diluted shares, including how various factors—such as stock options, convertible debt, and restricted stock—affect a company’s share count.

We explain how failing to account for potential shares that could be issued (like employee stock options or convertible debt) can lead to overvaluing a company’s equity. By breaking down the differences between basic shares outstanding and fully diluted shares, we can begin to see how these complexities can impact financial valuations.

We also discuss how convertible debt and preferred stock can convert into shares and cause dilution. Through practical examples, including a case study on a well-known supermarket chain, we walk listeners through the step-by-step process of calculating the impact of these conversions on the total share count. This approach makes a complex topic more approachable and easier to understand.

Transcript

Asim (00:14)
Hello and welcome to the What’s New at CFI podcast. My name is Asim Khan. I’m joined today by Scott Powell, our chief content officer and co-founder. Welcome to the podcast, Scott.

Scott (00:24)
Thanks, awesome. Pleased to be here.

Asim (00:27)
Great to have you. So I’m excited about this talk because you’ve just published a course on a subject on which I have great interest because it took me some time to wrap my head around it. And that’s Accounting for Diluted Shares.

Scott (00:41)
Yes, exactly. I’ll tell you, our learners asked for it, but having taught it in the classroom for 20 plus, 30 years, I mean, to be honest, it’s more like 30 years, is that it often confuses people and we just wanted to create something that was so straightforward and so applied in Excel that everyone would get it.

Asim (01:02)
So, in general, just what is this diluted shares business and why is it important?

Scott (01:08)
Yeah.

So I’m mindful of our time, but we actually go through, we create a primer just to make sure we’re all speaking the same language. Like what’s authorized versus issued shares versus outstanding shares or stock. We explain what treasury stock is, which is when we’re buying back stock as a company. And then basically one of the things we sometimes fail to realize is that we look at the shares outstanding and we think, great, that’s it. And if we wanna do evaluation and calculate a target earnings per share, or not target valuation,

per share, I should say. You just take the equity value and divide it by the basic shares outstanding and if you do that you really miss the point because there’s lots of things that could be shares that aren’t shares now. Things that convert to shares. Things like stock options.

And one of the things that’s really important and is the kind of rule, the benchmark in terms of valuation is we always want to use an evaluation, the fully diluted shares outstanding, which means you typically are going to have to do some calculations so that you’re not overvaluing the share. Because you think about it, if we have the same equity value and we divide it by 100 shares, that’s great. But if we divide it by 1000 shares, that’s going to have a material impact on the value of each share.

Asim (02:32)
Right, so I guess the premise here is in an acquisition, whatever can be converted to stock is converted to stock, right? So, just going down the list, what are those things? In the money, stock options, for example.

Scott (02:49)
Yeah, again, I encourage you to check out the course because I’m using it. We’ll be using us. We know this, but we’re going to use a lot of jargon. And if it’s jargon, check out the course. We demystify all this jargon and then we go into Excel and do some practical examples. But,

so stock options typically are given to employees and they’re allowed to buy those shares. It basically gives them the option to buy the shares at a specific price. And we call that price an exercise price or strike price. So let’s say we get to buy the share at $3. But we know the shares trading at $5.

That would be great. I’m going to buy the shares for $3 and sell them immediately and make $2 profit. And that’s an in-the-money stock option. And so one of the things that we have to, we’re going to assume when we dilute the shares outstanding is we’re going to say anything that’s in the money, the rational employee is going to exercise that and we’re going to have more shares. So we’re going to have some dilution there. But we also have to think about sometimes people, especially executives, are given restrictive stock.

So they’re given at not options, they’re given the stock based on meeting certain criteria. So certain profitability, revenue targets, it might be share price if you’re very senior. So, we need to think about restrictive stock grants or restrictive stock units. But you mentioned something else that’s really important. There’s other types of securities that can be triggered at a point in time to convert into shares.

One of them is convertible debt. So again, you may want to check out a convertible debt course, but convertible debt is simply bonds, typically bonds that based on the investor’s choice, they can convert it into equity at a certain stock price.

But it works very similar to stock options. If I can convert my $1,000 bond into four stock options, or four, sorry, four stock, that would be, that’s $250 a share. I’m only gonna do that if I can sell those shares for more than 250. So one of the things we do with convertible debt and also preferred stock, preferred stock’s very similar, is we basically have to do a calculation of if converted.

Asim (04:52)
Right.

If it’s convertible preferred, then you know. So you’re basically taking account of everything that could be converted, reasonably, and converting it, and now you’ve got the fully diluted outstanding shares, correct?

Scott (05:07)
Yeah, you got it.

You got it. And just as this maybe this is too much detail, but generally convertible debt is structured to convert into equity. Although I show you in the course an example where it didn’t. And it’s, but generally, it does its price so that, given where the stock price is going, that really by the time it there’s the ability to convert, those bondholders are going to want to convert. 

But we look at a company in the US called Peloton that had convertible debt, but they issued the convertible debt when the stock was trading at $160. And I think it’s trading now at $4.

Asim (05:50)
Dear. Yeah.

Yeah, I really crashed after the COVID lockdown ended. So yeah, that’s absolutely not converting. OK, so there’s also something when you’re calculating the DSO, Diluted Shares Outstanding, there’s something called the Treasury Stock Method. Can you just, I know it’s in detail in the course, has to be, right? But in your own words, if you could tell us how that operates.

Scott (06:00)
Cool. So, the Treasury Stock method works like this. Now, in reality, go to the notes of the annual report of the 10K, and you’ll often find there are different stock options with different strike prices. And the first thing you’re going to do is identify which stock options right now, with the current share price, are in the money. And we calculate that number of shares. Anything that’s out of the money, we ignore.

Then what we say is, okay, let’s imagine they exercise those options. Remember, I gave you the strike price of $3, so I buy these options for $3. And let’s say I had the right to buy 10 shares. So I give the company $30, I get the shares, I go out and sell them for $50, right, $5 each.

Now, what does the company do with that $30? Well, we could say it puts it in cash, but what the Treasury Stock method says is, no, we want to minimize dilution. That’s rational because then the share price is going to be higher. So any cash we get in, we’re going to immediately go out into the market and buy back shares. So, at $30, I can only remember it’s $5 a share, I can buy back six shares.

So, really, the dilutive effect is only the difference, right? We gave 10 shares out, but we bought six shares back. So the really dilutive effect is the four, the difference. And that’s the Treasury Stock method.

Asim (08:20)
That’s a great way of explaining it. Yeah. Because, you know, I mean, you look at that formula, it’s like one over n times p over k. It’s like, what’s going on here? So yeah, if you’re new to it, it can confuse you. Anything else you’d like to add, Scott?

Scott (08:41)
The only thing, well, a couple of things, because I just love this stuff. One, if you’re doing valuation, you have to do this course because you need to know how to calculate fully diluted. Remember, we are always going to use the fully diluted shares outstanding to calculate a target share price. So you need to do this. And because I’ve taught in so many companies, including

sell-side banks, asset managers. I have taught this thousands of times because it’s so important to calculate. Second thing that I think is really cool is we build this up with practical examples in Excel, but then we look at a real company and we calculate it. And we’re looking at it. Yeah, we look at a supermarket chain in the U.S. called Kroger.

And we basically try to investigate, are there stock options that are in the money? Is there restricted stock? Are there convertibles we need to worry about? Are there preferred stock? We go through all the calculation at the end. You’ve calculated it for a real company.

So we’re hoping we give the learner confidence that we just didn’t do it with fake companies. We actually did it with a real company. So you should now be comfortable doing it with any company.

Asim (09:43)
Okay, so I guess I can ask the dangerous question.

Scott (9:46)
Do it.

Asim (09:48)
The company will also, at the bottom of the income statement, tell you what the diluted shares outstanding are. Did your calculation match Kroger’s?

Scott (09:57)
So here’s the deal. One of the things we also teach is we have to be careful of what we’re looking at when we look at earnings per share, for example, and shares outstanding versus shares outstanding for valuation. So, the answer is yeah, but not yeah. And because when we look at calculating earnings per share and diluted earnings per share, we’re going to use a weighted average. Okay?

Asim (10:21)
Yeah.

Scott (10:22)
But when we do valuation, we don’t use weighted averages. We use the shares outstanding on a specific date. Right?

Asim (10:28)
Yeah. Okay.

Scott (10:30)
So that’s a great question. And we actually go through that because it’s confusing. Like, but it’s just, I hope I’m my biggest message here is shares outstanding at the one date, but for any EPS calculation, it’s average. And we show you how to calculate that.

Asim (10:46)
Very comprehensive treatment there. All right. Yeah.

Scott (10:50)
Ha-ha.
We try to be.

Asim (10:52)
All right, Scott. Well, thank you so much for those insights. And I encourage everyone to check out the course, Accounting for Diluted Shares. And we’ll see you back again soon. Thank you.