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The number of shares outstanding in a company will often change due to a company issuing new shares, repurchasing shares, and retiring existing shares. The number of outstanding shares can also change if other financial instruments are turned into shares. An example of this is when employees of the company convert their employee stock options (ESO) into shares.
The weighted average of outstanding shares is a calculation that incorporates any changes in the number of a company's outstanding shares over a reporting period. The reporting period usually coincides with a company's quarterly or annual reports. The weighted average is a significant number because companies use it to calculate key financial measures with greater accuracy, such as earnings per share (EPS) for the time period.
Calculating a weighted average of outstanding shares is important because it allows a company to calculate its earnings per share (EPS), which is a measurement of how much money a company makes for each share of its stock. Potential investors in a company look at the EPS as an indicator of the company's profitability and compare this metric with the EPS of other companies before making an investment decision.
For example, let's say a company has 100,000 shares outstanding at the start of the year. Halfway through the year, it issues new shares in the amount of an additional 100,000 shares. Thus, the total amount of shares outstanding increases to 200,000.
If at the end of the year the company reports earnings of $200,000, which amount of shares should be used to calculate earnings per share (EPS): 100,000 or 200,000? If the 200,000 shares were used, the EPS would be $1, and if 100,000 shares were used, the EPS would be $2—this is quite a large range! To avoid the confusion caused by such a large range, the company must calculate the weighted average of outstanding shares to arrive at a more accurate EPS for the given time period.
This potentially large range is the reason why a weighted average is used, as it ensures that financial calculations will be as accurate as possible in the event that the amount of a company's shares changes over time. The weighted average number of shares is calculated by taking the number of outstanding shares and multiplying the portion of the reporting period those shares covered, doing this for each portion and, finally, summing the total.
The weighted average number of outstanding shares in our example would be 150,000 shares.
The earnings per share calculation for the year would then be calculated as earnings divided by the weighted average number of shares ($200,000/150,000), which is equal to $1.33 per share.
Understanding how to calculate a weighted average can also be useful to individual investors who want to calculate their cost basis. The cost basis refers to the original purchase price of an asset or investment for tax purposes. Investors calculate the cost basis to determine if their investment has been profitable or not, along with any possible taxes they might owe on the investment.
Because investors frequently purchase shares of a company at various times and in various amounts as they build their position in a stock, it can be a challenge to keep track of the cost basis of those shares. One method is for the investor to calculate a weighted average of the share price paid for the shares. The investor would multiply the number of shares acquired at each price by that price and then add those values together. Lastly, divide the total value by the total number of shares purchased to arrive at the weighted average share price.
Shares outstanding refers to the amount of stock held by shareholders, including restrictive shares held by company insiders. A company, however, may have authorized more shares than the number of outstanding but has not yet issued them. These may later appear in the form of a secondary offering, through converting convertible securities, or issued as part of employee compensation such as stock options. Due to these factors, the actual number of shares outstanding can vary over the course of a reporting period.
A company may authorize buying back some of its own shares in the market if they believe that the market is undervaluing them and there is enough cash on the balance sheet to do so. After shares are repurchased, they are often retired. In this case, the number of shares outstanding for the firm decreases. The number of shares outstanding can also be reduced via a reverse stock split.
Using weighted average shares outstanding gives a more accurate picture of the impact of per-share measurements like earnings per share (EPS). Note that this method does not account for shares that can be potentially released through various mechanisms, so a weighted average shares outstanding will not tell you the diluted EPS.
