How to Compute Earnings Per Share (Basic and Diluted)

Earnings Per Share (EPS) is a financial metric that indicates the portion of a company’s profit allocated to each outstanding share of common stock. It serves as a key indicator of a company’s profitability from a per-share perspective, allowing investors and analysts to assess how much profit the company generates for each share they own.

Components of Basic Earnings Per Share

Calculating basic earnings per share requires two primary components: net income attributable to common shareholders and the weighted average common shares outstanding. Net income attributable to common shareholders represents the profit available to common stockholders after all expenses, taxes, and dividends to preferred shareholders have been accounted for. This figure is derived by subtracting any preferred stock dividends from the company’s total net income.

The weighted average common shares outstanding reflects the equivalent number of whole common shares that were outstanding throughout a specific reporting period. This weighted average is used instead of a simple end-of-period share count to accurately match the income generated over the period with the shares that were outstanding during that time. Various corporate actions can influence this number, including the issuance of new shares, the repurchase of existing shares (treasury stock), and events like stock splits or stock dividends. Each change in the number of shares is weighted by the fraction of the reporting period it was outstanding.

Computing Basic Earnings Per Share

Basic earnings per share is computed by dividing the net income attributable to common shareholders by the weighted average common shares outstanding. The formula is: Basic EPS = (Net Income Attributable to Common Shareholders) / (Weighted Average Common Shares Outstanding).

To illustrate, consider a company with a net income of $500,000 for the year and preferred dividends of $50,000. This results in net income attributable to common shareholders of $450,000. If the weighted average common shares outstanding for the year was 200,000 shares, the basic EPS would be $2.25 ($450,000 / 200,000 shares). This means that for every common share, the company generated $2.25 in profit available to its common shareholders.

Components of Diluted Earnings Per Share

Diluted earnings per share (EPS) offers a more conservative view of a company’s profitability by considering the potential impact of certain securities that could increase the number of common shares outstanding. This concept, known as dilution, illustrates a “worst-case scenario” by assuming that all convertible securities that would reduce EPS are converted into common stock.

Several types of securities can lead to dilution. Stock options and warrants, which give holders the right to purchase common shares at a specified price, are common examples. Their dilutive effect is typically calculated using the treasury stock method, which assumes that any proceeds from the exercise of these options are used by the company to repurchase its own shares in the open market.

Another category includes convertible bonds, which are debt instruments that can be exchanged for a predetermined number of common shares. The “if-converted” method is applied here, assuming conversion at the beginning of the period, which eliminates interest expense (net of tax) and increases the share count. Similarly, convertible preferred stock, which can be exchanged for common shares, also contributes to dilution. The if-converted method for convertible preferred stock assumes conversion, meaning preferred dividends would no longer be paid and the common share count would increase.

An important consideration in diluted EPS calculations is antidilution. Securities are considered antidilutive if their hypothetical conversion or exercise would result in an increase in earnings per share or a decrease in loss per share. These antidilutive securities are excluded from the diluted EPS calculation because the goal is to present the maximum potential dilution.

Computing Diluted Earnings Per Share

Computing diluted earnings per share involves adjusting both the numerator (net income) and the denominator (weighted average shares) of the basic EPS calculation to reflect the potential conversion of dilutive securities.

For stock options and warrants, this method adds to the denominator the net increase in common shares that would result if the options or warrants were exercised and the hypothetical proceeds were used to repurchase shares. For example, if exercising options generates $1,000,000 and the average market price is $20, the company could repurchase 50,000 shares. If 100,000 shares were issued upon exercise, the net increase in shares would be 50,000 (100,000 issued – 50,000 repurchased). For convertible bonds, the “if-converted” method adds back the after-tax interest expense associated with the bonds to the numerator, and the number of common shares into which the bonds are convertible is added to the denominator. In the case of convertible preferred stock, the preferred dividends are added back to the numerator, as they would not have been paid if the shares were converted, and the common shares obtainable from conversion are added to the denominator.

After calculating these adjustments for all dilutive securities, the adjusted net income is divided by the adjusted weighted average common shares outstanding to arrive at diluted EPS. For example, if the net income attributable to common shareholders was $450,000 and weighted average shares were 200,000, but there were convertible bonds that, if converted, would add $20,000 (after-tax) to net income and 10,000 shares to the denominator, the diluted EPS calculation would use $470,000 ($450,000 + $20,000) as the numerator and 210,000 shares (200,000 + 10,000) as the denominator, resulting in a diluted EPS of approximately $2.24. Diluted EPS is typically lower than basic EPS, providing a conservative measure of earnings per share.