A company has 1 million shares outstanding at a value of $100 per share. It also has $10 million of convertible bonds, with par value of $1,000 and a conversion price of $50. How do I calculate diluted shares outstanding?

This gets confusing because of the different units involved. First, note that these convertible bonds are in-the-money because the company’s share price is $100, but the conversion price is $50. So we count them as additional shares rather than debt.

Next, we need to divide the value of the convertible bonds – $10 million – by the par value – $1,000 – to figure out how many individual bonds we get:

$10 million / $1,000 = 10,000 convertible bonds.

Next, we need to figure out how many shares this number represents. The number of shares per bond is the par value divided by the conversion price: 

$1,000 / $50 = 20 shares per bond.

So we have 200,000 new shares (20 * 10,000) created by the convertibles, giving us 1.2 million diluted shares outstanding.

We do not use the Treasury Stock Method with convertibles because the company is not “receiving” any cash from us.