Understanding the difference between weighted average and diluted shares can be helpful in evaluating a company’s financial performance. These terms are often used when analysing earnings per share (EPS), a standard metric used by dividend growth investors.
Let’s try and break them down with examples from well-known companies.
Weighted Average Shares
Weighted average shares represent the average number of shares outstanding during a specific period, typically a fiscal quarter or year. This calculation adjusts for changes in the share count, such as new issuances or share buybacks, and weights these changes based on the time they were in effect.
Nestlé frequently engages in share buybacks to return value to its shareholders. Now, I say return value, but readers of our newsletter will know that they use debt to fund these buybacks. Let’s ignore this for this example.
Suppose Nestlé starts the year with 1 billion shares outstanding but buys back 50 million shares midway through the year. Instead of simply using the starting or ending share count, the weighted average calculation considers how long the 1 billion shares were outstanding (6 months) and how long the reduced count of 950 million shares applied (the remaining 6 months).
To calculate the weighted average, use this formula:
Where
- Shares Outstanding T1 = 1,000,000,000
- Share OutstandingT2 = 950,000,000
- T1 = 6
- T2 = 6
- Total Time = 12
Weighted Average Shares = (1,000,000,000×0.5) + (950,000,000×0.5)
Weighted Average Shares=500,000,000 + 475,000,000 =975,000,000
Thus, the weighted average number of shares outstanding for the year is 975 million shares.
While the weighted average shares aren’t broken down on the income statement, details about the calculation can sometimes be provided in the notes in the financial statements, but not always. Weighted average shares provide a more accurate representation of the shares outstanding over the year, which is crucial for calculating metrics like EPS.
Diluted Shares
Diluted shares, often called fully diluted, represent the total number of common shares that would be outstanding if all potential conversion sources were exercised. These include:
- Currently issued and outstanding shares.
- Shares that could be converted from convertible bonds or preferred stock.
- Shares issuable upon exercising stock options or warrants.
- Shares issued under Stock-Based compensation plans
The diluted share count is always equal to or greater than the basic share count because it accounts for potential future issuances.
Example: IBM
For the year ended in 2023, IBM reported average weighted shares of 911 million. Accounting for shares issued for stock-based compensation plans to keep top talent in their crown jewel, Red Hat, and for performance-based shares, the diluted shares are 922 million.
When calculating diluted EPS, this larger share count reduces the earnings per share, providing a more accurate view of profitability. This helps us understand the potential impact of future dilution. When calculating Earnings per share, remember:
- Basic EPS uses the weighted average share count. This is $8.23 for IBM above
- Diluted EPS uses the fully diluted share count. This is $8.14 for IBM above
Ownership Percentage
As shown above, Diluted shares represent the potential reduction in ownership caused by future share issuances, such as stock options, convertible securities, or other equity-based instruments.
For example, imagine you own 1% of LVMH, the French luxury conglomerate. With 1 billion shares outstanding, you own 10 million shares. Now, if stock options and convertible securities are exercised, adding 100 million new shares, the total share count rises to 1.1 billion. In this fully diluted scenario, your ownership shrinks to approximately 0.91% (10 million ÷ 1.1 billion).
Dilution can be particularly significant for long-term investors who aim to maintain substantial ownership stakes, as it reduces both their share of profits and voting power over time.
Valuation
Analysts and retail investors sometimes rely on basic and diluted earnings per share (EPS) to assess a company’s value and financial performance.
For instance, take IBM, analysts evaluating its price-to-earnings (P/E) ratio might calculate this metric using both basic and diluted EPS figures. While the basic EPS provides a straightforward measure of profitability based solely on current outstanding shares, the diluted EPS includes the impact of potential future share issuances, such as stock options, warrants, or convertible securities.
By incorporating diluted EPS, analysts gain a more conservative perspective on IBM’s valuation. This approach ensures that investors account for the possible effects of dilution, preventing overestimating the company’s performance or earnings power. Such diligence is particularly critical when assessing companies like IBM, which may use equity-based incentives as part of their compensation strategy.
Financial Planning and Strategy
Companies incorporate both weighted average and diluted share counts into their strategic planning processes. These metrics play a critical role in shaping critical decisions, including:
- Capital Structure Optimization
Management may evaluate their capital structure by analysing the impact of potential dilution on shareholder equity. For instance, issuing convertible bonds might raise capital without immediate dilution, but the diluted share count ensures the company assesses long-term effects on ownership and financial ratios, such as debt-to-equity. - Equity Compensation Plans
Energy companies, for example, often reward executives and employees with stock options or restricted shares. Using diluted share counts allows them to predict the impact of these equity-based incentives on earnings per share (EPS) and shareholder value. For example, Shell might structure its executive compensation to balance competitive pay while managing dilution, ensuring that long-term shareholders are not excessively impacted. - Share Buybacks and Dividend Distributions
Weighted average share counts help companies accurately estimate the cost of share buybacks or the distribution of dividends. For example, if TotalEnergies plans to repurchase shares, they use this figure to project how buybacks might offset the dilution from stock options, ensuring net EPS growth. Similarly, when declaring dividends, using the weighted average share count ensures precise calculation of per-share payouts.
Final Thoughts
Getting a handle on the difference between weighted average and diluted shares helps you better understand a company’s real earnings per share (EPS) figure. It’s more than just numbers, it’s about understanding how a company manages its equity and what that means for your potential returns.
- Weighted Average Shares give a balanced view of how share counts change over time, accounting for events like buybacks or issuances during the year. This approach helps smooth out the fluctuations and reflects a more accurate EPS for ongoing operations.
- Diluted Shares highlights potential future changes, showing the effects of stock options, warrants, and convertible securities. Think of it as a reality check; your slice of the pie could shrink if all those future shares hit the market.
When comparing basic and diluted EPS, you’re essentially seeing both today’s snapshot and tomorrow’s possibilities. For investors, this dual view helps assess a company’s financial stability, growth potential, and management strategies for rewarding shareholders.
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