Diluted earnings per share (EPS) is a measure of earnings per share that includes a company’s convertible securities. Convertible, or dilutive, securities are stocks or bonds that could potentially become common shares. Basic earnings per share only considers existing common shares.
Diluted EPS, then, includes in its calculation the factor of convertible bondholders, convertible preferred stockholders, and options holders potentially deciding to turn their securities into common shares. If this were to happen, the number of shares outstanding would increase, with earnings staying the same, resulting in lower earnings per share. Diluted EPS will therefore tend to be lower than basic EPS.
Basic vs. Diluted EPS
What is diluted earnings per share, and how does it differ from basic EPS? Simply put, basic EPS tends to be a higher number than diluted EPS. Basic EPS doesn’t factor in the existence of convertible securities of the impact if they were to be converted into common shares.
Instead, the most basic calculation of earnings per share only takes a company’s net income minus any preferred stock dividends and divides that number by the number of shares outstanding. Convertible securities aren’t factored into the equation.
Because of this, sometimes it’s beneficial to look at a calculation of earnings per share that assumes all possible common shares have been brought into being through existing convertible securities. Doing so gives investors a more realistic view of earnings while assuring no future surprises.
Imagine an investor doing all their homework on the fundamental analysis of a company using only basic earnings per share. EPS, which measures the value that a company delivers to individual shareholders, might look high and the stock pays a good dividend, so the investor might decide the stock is a good one to buy.
But then she learns that the company has been issuing convertible bonds to raise capital and giving new employees stock options to make working there more attractive.
All of a sudden, for some reason, bondholders decide to convert their bonds to common shares, and employees decide to exercise their stock options.
Now this investor’s shares have been diluted, since a bunch of new shares have popped into existence practically overnight. As a result, earnings per share have decreased, and dividends likely have done the same (because the same dividends now have to be paid out to additional shareholders).
If our imaginary investor had used diluted EPS in her calculations, she could have prepared for this kind of scenario at some point. But because this make-believe company created the potential for its stock to be diluted by issuing convertible securities, basic EPS did not provide the full picture.
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How to Calculate Diluted EPS
The formula for diluted EPS is a company’s net income minus any preferred stock dividends, divided by the company’s average outstanding shares minus its dilutive shares. Or:
Diluted EPS = (Net Income – Preferred Stock Dividends)/(Average Outstanding Shares – Dilutive Shares)
The diluted EPS formula is calculating the amount of earnings per share there would be if dilutive shares were to become common shares. The formula is exactly the same as that of calculating basic EPS, but with one important extra step – adding the number of dilutive shares to the number of average outstanding shares (in the bottom half of the equation).
The sum of both existing common shares and the possible dilutive shares creates a larger number on the bottom half of the equation, while the top half remains the same.
Therefore, diluted EPS tends to be lower than basic EPS, as the company’s net income (minus preferred stock dividends) is being divided by a larger number of shares.
For example, let’s say a company makes $1,000,000 in net income and pays no dividend. There are 800,000 common shares outstanding, 100,000 call options, and 100,000 convertible preferred shares.
The diluted EPS formula would yield a result of $1.00 per share in this example, as we would be dividing 1,000,000 dollars in net income by 1,000,000 total potential shares.
Basic EPS, on the other hand, would be calculated as $1,000,000 divided by the 800,000 current shares, yielding a result of $1.25 per share.
While it’s not difficult to calculate EPS and diluted EPS, many companies share the figures with investors in their earnings reports.
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Why Is Diluted EPS Important?
Diluted EPS reveals what a company’s earnings per share could look like if holders of convertible securities were to decide to exercise their right to hold common shares, and it’s an important consideration during an investor’s analysis of a stock.
Since companies often issue convertible securities like stock options, convertible bonds, convertible preferred shares, a company’s earnings per share could appear higher than reality when not factoring in the potential for dilution.
Convertible securities might be held by people inside or outside of the company, and they may not be turned into shares anytime soon. But what happens when everyone decides to turn in their convertible securities for shares?
For example, if a company’s stock were to rise in price suddenly, and the company had paid several of its employees bonuses in the form of stock options, those employees might choose to exercise those options.
Now there are more common shares than before, but earnings have not increased. Therefore, in a theoretical example like this, earnings per share will have decreased.
A company issuing employee stock options isn’t always a negative thing, however. If the options keep high-quality employees, the result could be positive for the company over the long run. Using options also reduces expenses that come from paying employee salaries, which could free up capital to help the company grow.
Diluted EPS provides a more conservative earnings per share number since it shows what EPS would be in the event of more new shares coming into existence. Basic EPS could appear to be deceivingly high because it doesn’t calculate for this possibility, so it could be a less reliable indicator of when to buy, sell, or hold a stock.
Of course, there might also be times when diluted EPS is unnecessary. Young companies that are still small and growing might not have had the chance to issue any convertible securities yet, so earnings per share might look the same either way.
The Takeaway
Diluted EPS is a measurement of earnings per share that factors in the potential stock dilution that occurs when convertible securities are converted to common shares. Understanding diluted EPS is important so that investors don’t get caught off guard in the event of new common shares being created through the conversion of securities such as stock options, stock warrants, convertible bonds and convertible preferred shares.
When this happens, earnings per share decline, and those who had only been looking at basic EPS in an attempt to determine the profitability of a company will find they made a miscalculation. In some cases, the difference between basic and diluted EPS might not be that different. If a company hasn’t issued convertible securities, or has issued very few convertible securities, then not much dilution would be possible.
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