Fully diluted shares outstanding (“FDSO”) is computed as basic common shares outstanding plus any share equivalents resulting from the hypothetical exercise of in-the-money (“ITM”) options and conversion of convertible securities.
We use the Treasury Method to compute the number of incremental shares that would be hypothetically created upon the exercise of ITM options. The Treasury Method assumes that, upon exercise of ITM options, the company receives proceeds equal to the number of options exercise multiplied by their exercise prices, and immediately uses the proceeds to repurchase its shares at the current stock price. So, the company’s FDSO is increased by X options exercised and is reduced by Y shares repurchased, where X > Y.
The options used to compute FDSO are those that are exercisable, rather than those outstanding. However, we have also included options outstanding in our table as these options would be required for modeling an acquisition or LBO of the company. This options detail is always disclosed in annual 10-K filings, but is less frequently disclosed in quarterly 10-Q filings. As such, you may need to use options data that is several quarters old.
When a convertible debt or preferred stock is converted, the number of common shares outstanding is increased, but the interest expense or dividend associated with the converted security is eliminated. As such, conversion increases the EPS denominator but also increases the numerator. Only when the impact to EPS is dilutive do we include convertible shares in the calculation of FDSO.
Note that when computing the impact to net income available to common shareholders of converting debt, we tax-effect the impact. However, we do not tax-effect the impact of converting preferred stock because preferred dividends are not tax-deductible (i.e. they are subtracted from earnings after taxes are computed).