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I'm learning a lot about investing because of The Motley Fool's books and this website. I'm even finding copies of financial statements for companies I invest in and plan to invest in. But I keep coming across the term "diluted" and I don't understand what it means. Thanks for your help in cleaning this up!
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Dilution is when a company's number of shares outstanding increases, making each share represent a smaller percentage of a company. For example, if there are 10 shares of Company A, each one is 10% of the company. If an additional share is issued, there will be 11, and each one will be only 9% or so of the company.

Here's what I wrote for our weekly newspaper feature on basic and diluted earnings: (more on our newspaper feature at: http://www.fool.com/specials/1999/sp991117paper.htm)

Selena

New and Improved Earnings Per Share

There are interesting changes afoot in how companies report their earnings. At the end of 1997, a new rule went into effect, instituted by the Financial Accounting Standards Board (FASB). It requires companies to report their quarterly earnings per share (EPS) in two ways.

This is important stuff for investors to understand, as corporate per-share profits are in many ways at the core of all things financial. Per-share profits show an investor her share of a company's total profits. The new EPS calculations are broken out in two ways: basic and diluted. Fools should pay attention to the diluted numbers.

Basic EPS is net income less any preferred stock dividends, divided by the weighted average number of common stock shares outstanding during the reporting period. Diluted EPS takes into account stock options, warrants, preferred stock and convertible debt securities, all of which can be converted into common stock. These common stock equivalents represent the potential claims of other owners on earnings and show the investor how much of the company's earnings she's entitled to, at a minimum.

Any increase in the number of shares of stock dilutes the earnings attributed to each share. The difference can be dramatic. For example, Dell Computer would have reported about $1.97 per share in basic earnings for the first nine months of fiscal year 1997, while fully diluted earnings were 9 percent lower, at $1.80 per share. Options and other securities would have added 32 million shares to the 334 million shares outstanding. Options are not all bad, though. Employee compensation in the form of options permits companies to attract and keep talented employees and also to reduce current salary expenses, leaving more money to help the firm grow.

Since many firms issue gobs of stock options, the new rules will help investors more accurately determine how much of company earnings they're entitled to and will impart a sense of what stock options actually cost a shareholder. The change will also align U.S. accounting standards with international standards being developed, ultimately helping investors compare companies around the globe.
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