What Are Diluted Earnings Per Share?

Earnings Per Share (EPS) is a financial metric that represents a company’s profit allocated to each outstanding share of common stock. It serves as a widely used indicator for investors to assess a company’s financial performance and overall profitability. A higher EPS generally suggests greater value, as it indicates the company is generating more profit per share. However, basic EPS provides only a partial picture because it does not account for potential future changes in the number of shares.

To gain a more comprehensive understanding of a company’s profitability, a “diluted” version of this metric is necessary. Diluted EPS offers a conservative and realistic estimate by considering future increases in the common share count. This adjusted measure helps investors evaluate the potential impact of various financial instruments that could convert into common stock, thereby affecting per-share earnings.

What is Basic Earnings Per Share

Basic Earnings Per Share (EPS) calculates the portion of a company’s net income attributable to each common share currently outstanding. This metric provides a straightforward view of a company’s profitability. The formula for basic EPS is: (Net Income – Preferred Dividends) / Weighted Average Common Shares Outstanding.

Net income represents the company’s profit after all expenses, including taxes, have been accounted for. Preferred dividends are subtracted from net income because these payments are made to preferred shareholders before any earnings are available to common shareholders. The weighted average common shares outstanding is used in the denominator to account for changes in the number of shares throughout the reporting period, such as new issuances or share repurchases. For example, if a company had $100 million in net income, paid $10 million in preferred dividends, and had 50 million weighted average common shares outstanding, its basic EPS would be $1.80 per share.

The Concept of Dilution

Dilution, in the context of Earnings Per Share, refers to the reduction in per-share earnings that would occur if all convertible securities were converted or exercised into common stock. Companies issue various financial instruments that, while not currently common stock, have the potential to become so, thereby increasing the total number of shares. This concept provides a more conservative view of a company’s profitability.

This potential increase reflects a “worst-case” scenario for earnings per share. The calculation of diluted EPS employs an “if-converted” or “as-if-exercised” assumption, hypothetically assuming these securities are converted at the beginning of the reporting period. This hypothetical conversion reveals the maximum potential reduction in earnings per share.

Securities That Cause Dilution

Several types of financial instruments have the potential to dilute Earnings Per Share by increasing the number of common shares outstanding. Stock options and warrants grant holders the right to purchase common stock at a specified price. If exercised, new shares are issued, adding to the total number of common shares and potentially reducing EPS.

Convertible bonds represent another source of potential dilution; these are debt instruments that can be exchanged for a predetermined number of common shares at the bondholder’s option. If bondholders convert their debt into equity, the share count increases. Convertible preferred stock pays a fixed dividend but can be converted into common stock. Its conversion directly adds to the outstanding share count.

Restricted Stock Units (RSUs) are grants of company shares that vest over a period, typically contingent on continued employment or performance. Once RSUs vest, they convert into common shares, increasing the total number of shares outstanding.

How to Calculate Diluted Earnings Per Share

Calculating diluted Earnings Per Share involves adjusting the numerator (net income) and the denominator (shares outstanding) of the basic EPS formula. The goal is to reflect the impact of all potentially dilutive securities as if converted into common stock.

Numerator adjustments are made for certain dilutive securities. For convertible bonds, the after-tax interest expense is added back to net income because, upon conversion, the company would no longer incur this interest payment. For example, if a company’s corporate tax rate is 21%, and it pays $100,000 in interest on convertible bonds, $79,000 ($100,000 (1 – 0.21)) would be added back to net income. Preferred dividends for convertible preferred stock are also added back to net income, as these dividends would cease if the preferred shares were converted.

Denominator adjustments involve adding the potential increase in common shares from each dilutive security to the weighted average shares outstanding. The “treasury stock method” is used for stock options and warrants. This method assumes that the proceeds from the exercise of these options are used by the company to repurchase its own shares, and only the net increase in shares (shares issued minus shares repurchased) is added to the denominator. For instance, if 10,000 options are exercised at $10 each, generating $100,000, and the average market price is $20, the company could repurchase 5,000 shares ($100,000 / $20), resulting in a net increase of 5,000 shares (10,000 – 5,000).

For convertible bonds and convertible preferred stock, the “if-converted method” is applied. This method assumes these securities were converted into common stock at the beginning of the reporting period, and the full number of common shares into which they would convert is added to the denominator. Only securities that would decrease EPS are included in the diluted EPS calculation; anti-dilutive securities, which would increase EPS, are excluded.