Dilution can be caused due to a number of dilutive securities such as stock options, restricted and performance stock units, preferred stock, warrants, and convertible debt. Dilution may cause the share price to decline because it reduces the company’s earnings per share (EPS). The extent of the decline depends on the percentage of dilution.
Given basic shares outstanding, share price, and information about dilutive securities, we can calculate dilution using the treasury stock method, and use the diluted number of shares outstanding and the market capitalization of the company to calculate its new share price.
The entire calculation of diluted shares outstanding and share price can be seen in the following example:
Step 1: Calculate the diluted number of shares outstanding using the treasury stock method
The treasury stock method assumes that all of the money securities are converted into additional shares and proceeds from these additional shares are used to repurchase the company’s shares. A security is considered in the money if its exercise price is below the market price.
Since the securities are converted into additional shares at a price less than the market price of the company’s shares, fewer shares can be repurchased from the proceeds of the conversion. As a result, there is a dilutive effect. If the securities are not in the money, there will be no dilution.
Step 2: Calculate the diluted shares outstanding by adding the additional shares issued due to dilution to the basic shares outstanding
Step 3: Divide the market capitalization of the company by the diluted shares outstanding to arrive at the new share price of the company
The new share price of the company will be lower than its share price before dilution. The reason for this is that the market capitalization of the company is divided by a greater number of shares. Dilutive securities cause the EPS of a company to decline. The markets factor this in, and the result is a decrease in the company’s share price.
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