When analyzing the value of a company, or when performing comparable company analysis, it’s important to see the effect of those securities that can be converted into common shares.
Potentially dilutive securities are, for example, stock options, warrants and convertible securities (like convertible debt/notes/preferred shares...).
In case of stock options and/or warrants, the Treasury Stock Method is applied in order to calculate the (potential) incremental shares outstanding.
The Treasury Stock Method implies that the money obtained from the exercise of options (at the ’’in-the-money’’ value) is used for the company’s stock repurchases (at the market price).
The formula to compute the additional shares outstanding with the Treasury Stock Method is:
n * [ 1 – ( K / P ) ]
where
n = number of shares from options/warrants
K = average exercise price
P = average share price
In case of convertible securities, the If-Converted Method is applied and the additional shares are =
number of in-the-money convertible securities / conversion price
In-the-money convertible securities are those with a convertion price that is lower than the share price (so that it’s convenient to convert them).
In the company’s filings it can be reported how many convertible securities there are, when they can be converted and what their convertion price is: this way it’s possible to look at how many convertible securities (which have a convertion price < share price) are potentially going to be converted into common stocks in the next years.
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