The term dilutive securities refers to financial instruments that are not in the form of common stock but can be converted to common stock. Examples of dilutive securities include convertible bonds and preferred stock, warrants and stock options.
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 issues to common stock lowers the risk of holding the security. Stock warrants may be issued to raise capital.
This type of security becomes dilutive when the holder exercises their right to convert it into shares of common stock. Once converted, the total number of shares outstanding increases, and the ownership of all shareholders is reduced.
The word diluted typically refers to the effect these securities can have on earnings per share. Since the earnings of the corporation are now divided among a larger number of shares, the earnings per share are said to be diluted.
There are circumstances whereby the conversion of dilutive shares has an antidilutive effect on earnings per share. For example, if a high yield bond were converted into common stock, the company’s interest expense decreases, which increases earnings. This can happen when a bond issue carries a high coupon rate.
When this occurs, the security can be excluded when calculating the company’s fully diluted earnings per share, which measures what happens if all of the convertible securities issued by a company are converted to common stock.