Summary - A key skill every investor needs to learn is how to analyze a company’s income statement. In order to do that, it’s important to understand the difference between a company’s basic earnings per share (basic EPS) and diluted earnings per share (diluted EPS). These numbers are used as the based for other ratios, most notably their price-to-earnings (P/E) ratio, PEG ratio, and the dividend-adjusted PEG ratio.
Earnings per share look at a company’s profits per share. This is important because no matter how much profit a company earns, the only number that an investor really cares about is how much of that profit makes its way to shareholders on a per-share basis. Some ways that earnings per share can be diluted include if new common shares are issued as part of a merger or acquisition, stock options or other dilutive securities. Most public companies make every effort to be shareholder friendly and will prioritize their per-share results with the understanding that when new shares are issued they are, in essence, selling off some of their current assets and giving them to the new shareholder.
For this reason, among others, companies who issue earnings reports based on generally approved accounting practices (GAAP) are required to provide investors with both a basic earnings per share figure and diluted earnings per share figure.
Basic EPS is simple and easy to calculate. It is simply a company’s net income divided by its outstanding common shares for the time period being measured. So if a company has 200,000,000 in net income and it started the year with 40,000,000 shares outstanding and ended with 35,000,000 shares outstanding, the earnings per share calculation would be: 200,000,000 /[ (40,000,000 +35,000,000)/2] = $5.33
Diluted EPS is slightly more complicated. This figure takes into account any potential dilutions to common shares. Although it is impossible for all of these conversions to happen simultaneously, diluted EPS is considered to be the most conservative measure that investors can have. If our example above included an additional 10,000,000 convertible preferred shares those would need to be accounted for. The calculation of diluted EPS would be:
200,000,000/[40,000,000 + 35,000,000/2 + 10,000,000/2]
200,000,000/37,500,000 + 5,000,000
200,000,000/42,500,000 = $4.70
Diluted EPS gives an investor a practical look at the effect potential dilution of stock can have on a company’s stock performance, particularly if the company is impacted by other macroeconomic events such as a recession or stock market collapse. Without accounting for that potential dilution, other measurements of a company’s valuation can be thrown off.
As investors, we always need to consider the worst case scenario when looking at a company we are considering making an investment in. The desire for investors to manage risk is always in opposition to a company's efforts to make their stock as desirable as possible. That's why in addition to a company simply reporting their revenue (called the top line) they will also report their earnings per share. Earnings per share are the amount of a company's profit that is assigned to a common share. However, companies have financial instruments such as convertible preferred shares and stock options that can dilute the value of those shares. Although most of that is theoretical, public companies that want to abide by generally accepted accounting practices (GAAP) will issue both a basic earnings per share (EPS) and their diluted earnings per share (Diluted EPS).
This article will provide an in-depth look at diluted earnings per share including key terms that will help explain the formula used in its calculation. We’ll also give a detailed example of how diluted EPS works and explain why it is an important measurement for investors.
What is diluted earnings per share (Diluted EPS)?
Diluted earnings per share is a metric that helps analysts and investors estimate the quality of a company’s basic earnings per share (EPS). The diluted EPS does this with a calculation that assumes all of a company’s convertible securities have been exercised. This is also referred to as finding a company’s fully diluted shares. Because it is rare for a company to have no additional potential shares of common stock outstanding, the diluted EPS will always be lower than the basic EPS. Diluted EPS can be looked at as a worst-case scenario for a company’s earnings per share number.
The formula for diluted EPS is:
Diluted EPS = (Net income – preferred stock dividends)/Weighted average shares outstanding + conversion of dilutive securities
Public companies are required to disclose earnings per share as part of their quarterly earnings. EPS and diluted EPS appear on a company’s income statement. When companies beat or exceed an analyst's estimates for EPS it is usually considered a sign of good financial health. Conversely, when a company misses on their EPS estimates, analysts see that as a warning that something is happening that requires further research.
Although both are considered important, many investors prefer to use diluted EPS because it is the more conservative number.
How is diluted EPS different from basic EPS?
- They have a different inherent meaning – Basic EPS measures the basic earnings of a company per equity share. Diluted EPS measures the basic earnings of a company per equity share.
- They have a different purpose – Basic EPS looks to find out the profitability of a company. Diluted EPS looks to find out the profitability of a company minus their convertible securities.
- They have different significance to investors – Basic EPS is less valuable because it doesn’t include convertible securities. Diluted EPS is more valuable because it factors convertible securities into its calculation.
- They include different data in their calculations – Basic EPS uses common shares. Diluted EPS uses common shares plus a variety of dilutive securities.
- They have a different measure of value – Basic EPS is higher because the denominator includes only common shares. Diluted EPS is less because the denominator also includes all convertible securities.
- They differ in ease of use – Basic EPS is very easy to calculate. Diluted EPS, while not hard, by comparison to the basic EPS can be somewhat complex.
Terms to help understand diluted EPS
- Earnings per share (EPS)– this is the portion of a company’s profit that is assigned to each share of a company’s common stock. The calculation for EPS is:
Net income + dividends paid for preferred stock / average number of shares outstanding
- Net income– this is a company’s income minus their cost of goods sold (COGS), expenses and taxes.
- Preferred dividends– these are the dividends that are accrued and are paid on a company’s preferred stock.
- Weighted average shares outstanding– this is a calculation that takes into account any changes in the amount of outstanding shares over a period of time.
- Dilutive securities– all in-the-money options, warrants, and other dilutive securities
- Warrants– derivatives that give an investor the right, but not the obligation to buy or sell shares
- Dilutive securities– any financial instrument that, if exercised, would increase the amount of common stock shares.
What are examples of dilutive securities?
- Convertible preferred stock– these are shares of preferred stock that can be converted to common shares at any time.
- Stock options– this is stock-based compensation that gives the owner the right, but not the obligation, to buy common stock at a set price at a set time.
- Convertible bonds– they are automatically converted to common shares at a price and time that is specified in the contract.
An example of diluted EPS
To help put it all together, we’ll show an example of how diluted earnings per share is calculated.
The ABC Company has a net income of 5,000,000. At the beginning of the year, the company had 4,000,000 shares outstanding. In the second half of the year, the shares outstanding increased to 4,500,000. The company also has the following dilutive securities:
- Unexercised stock options - $250,000
- Convertible preferred shares - $100,000
- Convertible debt - $125,000
- Preferred dividends - $20,000
The company has a 35% tax rate and they have $5,000 of annual interest.
Step One: Calculate the weighted average of dilutive common shares by multiplying outstanding shares by the “weight” assigned to the reporting period. In this case, the first six months of the year, the company had 4,000,000 shares outstanding and in the last six months they had 4,500,000 shares outstanding. The multiplier is 0.5 and the calculation is:
(0.5 x 4,000,000) + (0.5 x 4,500,000) = 2,000,000 + 2,250,000 = 4,250,000
Step Two: Calculate diluted EPS. To do this, simply plug in the numbers to fit the formula:
Diluted EPS = (Net income – preferred dividends)/Weighted average shares outstanding + conversion of dilutive securities)
Diluted EPS = (5,000,000 – 20,000)/4,250,000 + 250,000 + 100,000 + 125,000
Diluted EPS = 4,980,000/4,725,000 = 1.05
Why is diluted EPS important to investors?
Diluted EPS essentially tells investors how much of a company’s value is not available to them. It is highly unlikely that shareholders who own convertible instruments such as options, warrants, convertible preferred shares, etc. would all convert them at the same time. However, if a company is doing well, it is likely that if a company’s stock continues to rise, that shareholders would convert them over time. This means that there would be fewer outstanding shares available to investors. For example, if a company has 8 billion outstanding shares and a $0.10 difference between its basic EPS and diluted EPS, that amounts to $800 million dollars (in the form of common shares) that are not available to investors. In addition to its relationship to EPS, a company’s diluted EPS affects a company’s price-to-earnings (P/E) ratio.
The final word on diluted earnings per share
Diluted EPS is one measurement of a company’s earnings performance. As opposed to their basic EPS, a company’s diluted EPS takes into account the effect on their earnings if shareholders were to exercise all dilutive securities such as stock options, convertible preferred shares, convertible debt, and warrants.
Diluted EPS is considered to be one of the most conservative measures of a company’s overall financial health. Although it is generally agreed that it is impossible for a company to have all their shareholders convert all their dilutive securities at the same time, being able to show a strong diluted EPS number can give investors the confidence that a company was able to weather a worst-case scenario particularly if the company were to have to endure other macroeconomic events such as a correction in the stock market, unfavorable government regulation, or even a problem inside the company itself.
Diluted EPS is also important to investors because it has an effect on other valuation measures such as a company’s price-to-earnings (P/E) ratio.