How to Calculate Basic and Diluted Earnings Per Share

Earnings Per Share (EPS) is a measure of a company’s profitability allocated to each outstanding share of its common stock. A higher EPS can indicate greater profitability, which may make the company more attractive to investors.

Calculating Basic Earnings Per Share

Basic EPS is calculated using three components from a company’s financial statements: net income, preferred dividends, and the weighted-average number of common shares outstanding. Net income is the company’s total profit after all expenses, including taxes, and is found on the income statement. Preferred dividends are payments made to owners of preferred stock and are disclosed in the notes to the financial statements.

The formula is (Net Income – Preferred Dividends) / Weighted-Average Common Shares Outstanding. The dividends deducted for preferred stock include declared dividends for non-cumulative shares and the full required amount for cumulative shares, whether declared or not. A weighted average of shares is used because the number of shares can change throughout the year due to buybacks or new issuances.

For example, if a company reports a net income of $5,000,000, has $500,000 in preferred dividends, and a weighted-average of 10,000,000 common shares, the calculation is ($5,000,000 – $500,000) / 10,000,000. This results in a basic EPS of $0.45, meaning the company earned 45 cents for each share of common stock.

Understanding Diluted Earnings Per Share

Diluted EPS provides a more conservative measure of profitability by calculating per-share earnings as if all potentially dilutive securities were converted into common stock. Dilution is the potential reduction in EPS that occurs when the number of outstanding common shares increases. This calculation shows how certain financial instruments could spread net income over a larger number of shares if exercised.

Common types of potentially dilutive securities include:

• Stock options give holders the right to purchase company stock at a predetermined price.
• Warrants also give holders the right to purchase company stock at a set price.
• Convertible preferred stock can be exchanged for a set number of common shares.
• Convertible bonds can be exchanged for a set number of common shares.

Each of these instruments can increase the total number of common shares outstanding.

The calculation of diluted EPS shows a “what-if” scenario, assuming all conversions take place. Accounting standards, such as Accounting Standards Codification Topic 260, require companies to report diluted EPS alongside basic EPS on the income statement. This provides a more complete view of financial performance.

Calculating Diluted Earnings Per Share

To calculate diluted EPS, the numerator and denominator of the basic EPS formula are adjusted for the impact of all dilutive potential common shares. These adjustments assume the securities were converted at the beginning of the reporting period to determine the most conservative EPS figure.

The numerator (net income) is adjusted by adding back items that would not have been paid if conversion occurred. For convertible preferred stock, the preferred dividends subtracted for the basic EPS calculation are added back. For convertible debt, the after-tax interest expense associated with that debt is added back to net income.

The denominator is adjusted by adding the new common shares that would have been issued from conversions. For stock options and warrants, the “treasury stock method” is used. This method assumes the proceeds from exercising options are used to buy back company shares at the average market price. Only the net increase in shares is added to the denominator.

A security is only included in the diluted EPS calculation if it is dilutive, meaning its inclusion decreases EPS. If a security’s conversion would increase EPS, it is considered “anti-dilutive” and is excluded from the calculation for that period. For instance, a stock option is anti-dilutive if its exercise price is higher than the stock’s average market price.