What is diluted earnings per share (EPS)?
It is a calculation used to gauge the quality of a company’s earnings per share (EPS) if all convertible securities were exercised.
When a company is about to take up funding from an outside investor, the shareholders in the company find it important to check if their ownership will be diluted. And as the company grows, it offers equity through employee compensation plans, convertible debts, warrants, and others. And when these instrument holders exercise their options, the ownership of the company gets diluted.
That is what we will be talking about as we understand everything about basic and diluted EPS.
Earnings Per Share
Before we can talk about diluted earnings per share, let us talk about what earnings per share (EPS) are. EPS is calculated as the profit of the company divided by the outstanding shares of its common stock. The resulting number acts as an indicator of the profitability of a company, and its common for a company to report EPS adjusted for extraordinary items and potential share dilution. The higher a company’s EPS, the more profitable it is considered.
What is Diluted Earnings per share (Diluted EPS)?
However diluted EPS is different from basic EPS. It is a calculation used to gauge the quality of a company’s earnings per share (EPS) if all convertible securities were exercised. To be clear, the convertible securities are all outstanding convertible preferred shares, convertible debentures, warrants, and stock options. Unless a company doesn’t have any additional potential outstanding shares (which is rare), the diluted EPS will always be lower than the basic EPS.
Significance of EPS
Earnings per share are the value of shares of the outstanding common stock. It is a very important measure to assess the financial health of the company. In fact, when you are looking into the reported financial results of the company, the earnings per share and the revenue are the two most commonly assessed metrics. EPS is mainly reported on the income statement of the company and only public companies are required to report it.
In the earning reports of these companies, they need to report both the primary and diluted earnings per share. But the focus is normally on the more conservative diluted EPS measure. Dilutive EPS is considered a conservative metric since it displays a worst-case scenario in terms of EPS. It is not always likely that everyone holding convertible preferred shares, warrants and options would convert their shares eventually. Nonetheless, if things are going great, there is a chance that all of them will be converted into common stock.
Calculate Diluted EPS (Formula)
Companies usually issue additional shares, and with this, the existing shareholders’ ownership is often diluted. Hence, diluted earnings per share measures the EPS after a modified number of shares to account for the additional units. For a normal scenario where all the adjustments are there, the formula used is:
OR When considering the effect that stock options have on issued shares, we would consider the next formula: Diluted Earnings Per Share = (Net Income – Preferred Dividends) / (Shares Outstanding + Diluted Shares) Where Diluted Shares = Stock Options Issued – Value of Stock Options in Current Shares
When considering the effect that stock options have on issued shares, we would consider the next formula:
Diluted Earnings Per Share = (Net Income – Preferred Dividends) / (Shares Outstanding + Diluted Shares)
Where Diluted Shares = Stock Options Issued – Value of Stock Options in Current Shares
In addition to this, we would also have to determine the value of the payment made to exercise the options using: Amount Paid = (Options Issued) x (Exercise Price Per Share)
This is also followed by figuring the value of options in stocks using: Value of Options in Current Shares = Amount Paid to Exercise Options / Current Share Price
Let us take an example to understand this better. Assume there is a company called XYZ Ltd., and has the following information:
- Net Income: $100,000
- Common Outstanding Shares: 50,000
- Preferred Stock Dividend: $30,000
- Unexercised Employee Stock Options: 8,000
- Convertible Preferred Stocks: 20,000
- Convertible Debt: 10,000
- Warrants: 5,000
Here is how the company diluted shares would look in a table:
|Common Outstanding Shares||50,000||53.76%|
|Unexercised Employee Stock Options||8,000||8.60%
|Convertible Preferred Stocks||20,000||21.51%|
With these figures at hand, let us calculate the diluted earnings per share using the formula.
Diluted Earnings per Share Formula = (Net Income – Preferred Stock Dividends) / (Common Shares Outstanding + Unexercised Employee Stock Options + Convertible Preferred Stocks + Convertible Debt + Warrants)
Diluted EPS = ($100,000 – USD 30,000) / (50,000 + 8,000 + 20,000 + 10,000 + 5,000) = $0.75 per share.
Basic EPS vs Diluted EPS
It has been mentioned that diluted EPS vs basic EPS are not the same. In fact, basic EPS is calculated as the net income divided by the available shares. The formula for it is:
To calculate a company’s EPS, the income statement and balance sheet of the company are used to determine the period-end dividends paid on preferred stock (if any), number of common shares, and the net income or earnings.
On the other hand, diluted earnings per share are used to measure the quality of earnings per share of the company assuming all the convertible securities are exercised. The convertible securities here include all outstanding warrants, equity options (mainly employer-based options), convertible debts, and convertible preferred shares.
The formula used to get diluted EPS is the net income of the company minus preferred dividends divided by the weighted average number of shares outstanding plus the impact of convertible preferred shares and options, warrants, and other dilutive securities.
It is: Diluted EPS = Net income−Dividends on preferred stock / (Average outstanding shares+Diluted shares)
Let us take an example of this to understand it better using an existing company, Intel:
Intel is a technology company. Here are the details and the calculations for the diluted eps vs basic eps.
|IntelExcerpt: 2001 Annual Report|
|Earnings per share from continuing operations||2001||2000|
If you look at the table above, you will see that in 2000, the difference between the diluted EPS vs basic EPS amounted to around 0.06. And if we considered that the company had about 6.5 billion outstanding shares, the dilution was taking away more than $390M in value from the investors. This was a huge amount of money.
Later in 2001, as the market kept falling, a lot of the stock options went underwater. And that is when the dilution effect evaporated temporarily in the calculation of diluted EPS. In short, it can be seen that when everything gets converted and the capital entering the company is less, the diluted earnings per share would have a much lower value than the basic EPS.
We have covered the important aspects of what EPS and diluted EPS are. These figures can have a huge impact on the financial health and how investors perceive the company. But the most important aspect to find before calculating your diluted EPS is the number of fully diluted shares.
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