The term antidilutive securities refers to financial instruments that are not in the form of common stock, but when converted into common stock will increase earnings per share.
A transaction can have an antidilutive effect on the earnings per share calculation if the proportional increase to the number of shares outstanding is smaller than the proportional increase to earnings.
Companies will issue dilutive securities for a number of reasons. Convertible bonds and preferred stock may include this feature to attract investors, since the ability to convert these investments to common stock lowers the risk of holding the security. When converted, the total number of shares of common stock increases and the ownership of all shareholders is reduced.
There are circumstances whereby the conversion of dilutive securities has an antidilutive effect on earnings per share. This can happen when the proportional effect on the denominator of the earnings per share calculation (shares outstanding) is smaller than the proportional effect on the numerator. For example, a high yield bond converted into common stock will increase the number of shares outstanding, but it will also decrease interest expense. If the bond has a sufficiently high coupon rate, the lower interest expense can increase earnings to a greater degree than the increase to shares outstanding.
Business transactions can also have an antidilutive effect if it increases earnings per share. A transaction is considered to be antidilutive if its effect is to increase the amount of EPS, either by lowering the share count or increasing earnings. For example, a company can acquire another by issuing additional shares of common stock; however, the acquired company will also contribute to the earnings of the combined company. If the transaction causes EPS to increase, it would be termed an antidilutive acquisition.
When antidilution occurs, the security or transaction should be excluded when calculating the company’s fully diluted earnings per share.