By John W. Schoen Senior Producer
msnbc.com

Q: I have noticed the term “diluted share” used more frequently in financial reports. What is a diluted share and how did this term evolve. — Lloyd J.

A: Companies have taken a lot of flak recently for watering down their financial reporting, but in this case reporting on dilution means giving you more information — not less.

In this context, “dilution” refers to the effect of adding more shares to the pool of stock that is already trading in the open market. For example, if you own stock in a company with 1 million shares trading at $10 each, and the company decides to issue another 1 million shares, you’re holdings would be “diluted” by those new shares. Since the company hasn’t done anything to increase its value, the stock would drop to $5. It’s not much different than what happens to your savings when the government starts printing too much money.

Extra shares can be issued for a variety of reasons, but one common source is “convertible preferred shares” — a special class of stock that allows the holder to convert those shares to common stock. (Preferred shares, which often pay a special dividend, are really more like bonds than stocks.)

As companies issue more of these shares, the impact of the potential conversion is often overlooked by investors who don’t know — or don’t take the time to learn — just how much preferred stock is out there.

So when you see, for example, a company’s profits reported on a “fully diluted per share basis” it just means those results take into account the number of common shares that may not be on the open market now, but could be if those preferred shareholders decide to convert to common.

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