The financial ratio fully diluted earnings per share allows the investor to understand the impact to earnings per share if all of the investors holding securities convertible to common stock were to exercise that right.
Fully Diluted EPS = Net Income / (Shares Common Stock + Convertible Securities)
Note: It would not be appropriate to both lower net income by preferred dividends and include those same preferred securities in the convertible calculation.
Diluted earnings per share is a hypothetical measure that allows investors to understand the potential impact to earnings per share if all the rights of convertible securities were exercised by their holders. Convertible security is an all encompassing term and often includes convertible shares of preferred stock and stock options granted to employees. It can also include warrants and convertible bonds.
Most companies will have some form of convertible security. For that reason, the following relationship will always be true:
Fully Diluted EPS is always less than or equal to EPS
While it's very unlikely that all convertible options will be exercised, investors need to understand the magnitude of this risk. If there is a relatively large difference between EPS and fully diluted EPS, and the price of the company's stock increases significantly, there is a higher probability that conversions will take place. These conversions will result in a larger number of common shares outstanding, thereby lowering all common stockholders' EPS.
Company A's income statement indicates net income of $4,283,000, and payment of $500,000 in preferred dividends. The weighted average number of common shares outstanding for this same time period was 706,766. Company A also has 50,000 shares of preferred stock, convertible to common stock on a 2:1 basis.
The net income available to common stockholders would normally be calculated as:
= $4,283,000 - $500,000, or $3,783,000
Diluted shares outstanding would be:
= 706,766 + (2 x 50,000)
= 706,766 + 100,000, or 806,766
Note: This example assumes all preferred stock is convertible to common stock. To avoid double-counting this effect, net income would not be adjusted by the preferred shares' dividends. Company A's fully diluted EPS would then be:
= ($4,283,000 - $0) / 806,766, or $5.30 per share