What is Diluted EPS?
How do you calculate a company’s diluted earnings per share?
How does it work?
In this article, I will break down the meaning of Diluted EPS so you know all there is to know about it!
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Let me explain what “diluted EPS” means and see why it’s important!
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Table of Contents
What Is Diluted EPS
Diluted EPS, or diluted earnings per share, refers to a measure of a company’s earnings in relation to all its outstanding shares along with all possible convertible securities that may be converted into shares of the company.
The diluted earning per share can be contrasted with a company’s basic earning per share.
The basic earnings per share refers to a measure of a company’s earnings in relation to all the shares it has issued and outstanding.
According to Investopedia, a company’s diluted earnings per share is defined as:
Diluted EPS is a calculation used to gauge the quality of a company’s earnings per share (EPS) if all convertible securities were exercised.
Let’s look at a quick example to illustrate this.
If a company reports a revenue of $100,000,000 and has 100,000 shares outstanding, its basic earnings per share will be $10 per share ($100,000,000 / 100,000 shares).
Now imagine that the company has issued convertible securities like preferred shares, convertible bonds, warrants, stock options, or other types of securities convertible into an additional 100,000 common shares, then we could measure the company’s earnings using EPS diluted.
In this case, calculating diluted EPS will require that you take the company revenues ($100,000,000) and divide it by (200,000) giving you a $5 earning per share.
Why Are Diluted Earnings Per Share Is Important
Investors, stock analysis, finance experts, company shareholders (among others) calculate the company’s “diluted EPS” to assess the company’s overall financial health.
A company’s revenue figure along with the company’s earnings per share represent two of the most assessed metrics by investors, shareholders, analysis, and the market in general.
In the United States, public companies are required to report their diluted EPS so investors and the public are made aware of the company’s financial stamina.
Typically, by looking at a company’s income statement, you will find the company diluted vs basic EPS.
When a company reports a positive earning per share and that its earnings are higher than its peers or companies in its industry, the financial markets see that in a positive light.
However, if a company reports negative diluted earnings per share, investors should take more precautions and assess the company’s financial health before making an investment decision.
The earnings per share diluted in itself is not a measure that provides the full picture of a company’s financial position but provides some insights when used with other financial metrics.
Diluted Earnings Per Share Calculation
How do you calculate diluted EPS?
The calculation of a company’s “diluted” earnings per share is quite simple.
The generic formula to calculate diluted EPS is as follows:
EPS = (NI – PD) / (OS + DS)
- EPS = Earnings Per Share
- NI = Net Income
- PD = Preferred Dividends
- OS = Outstanding Shares
- DS = Diluted Shares
Let’s take an example where we have the following parameters:
- Company ABC has 500,000 issued and outstanding common shares
- Company ABC has reported a net income of $50,000,000 this year
- The company has granted 100,000 in stock options to its key employees
- The company has issued convertible bonds that can be issued into 400,000 common shares of the company
Now, in this example, the diluted EPS formula that we should use:
Diluted EPS = [ Net Income / (Common Shares + Stock Options + Convertible Bonds) ]
In essence, we need to divide the company’s net income of $50,000,000 by the sum of the company’s outstanding shares (500,000) along with the total number of common shares that may be issued if the stock options were exercised (100,000) and the convertible bonds converted (400,000).
Therefore: $50,000,000 / (500,000 + 100,000 + 400,000) = $50.
The company’s diluted earning is $50 per share.
If you calculate the company’s basic earning per share, you’ll need to divide its net income by the outstanding number of shares issued ($50,000,000 / 500,000 = $100 per share).
Diluted EPS vs Basic EPS
What is the difference between basic and diluted EPS?
The main difference between diluted EPS vs EPS is that you must assume that all convertible securities are exercised to calculate the “diluted” earnings per share whereas you do not make such an assumption to calculate the company’s standard EPS.
Both diluted and basic earnings per share measure a company’s earnings on a per-share basis.
However, the diluted EPS considers the company’s earnings per share if all the dilutive securities were exercised, you get a more conservative calculation of the company’s earnings capacity.
When the difference between a company’s basic vs diluted EPS is small, it means that the company does not have a lot of “convertible” securities that may potentially dilute the ownership interest of the current shareholders.
However, if there’s a large difference between the company’s basic and diluted EPS, the market will not consider that to be a positive factor for the company.
If things are going well for the company and there’s an acquisition or scenario where all the convertible securities are exchanged into common shares, the current shareholders will lose a much larger value in the company due to the dilution of the shares.
Here is a list of the main differences between basic vs diluted EPS:
- Basic EPS measures profitability whereas diluted EPS is a more conservative measure
- Basic EPS applies to all companies whereas diluted EPS applies to companies with a more complex capital structure
- Basic EPS does not consider the conversion of all dilutive securities whereas diluted EPS does
- Basic EPS is generally higher in value than diluted EPS
What Securities Can Dilute A Company’s Earnings
There are different types of securities a company may issue that are not common stock but can eventually be converted into common stock.
When a company has issued convertible securities into common stock, then the current shareholders can have their share position “diluted” when the convertible securities holders exercise their rights to get the common stock of the company.
For example, if a company has issued warrants convertible into common shares of the company, then when the warrant holder exercises his or her warrants into common shares, the current common shareholders of the company will see their ownership interest get diluted.
Here is a list of different types of securities that may be converted into company common stock:
- Convertible preferred stock
- Convertible bonds
- Stock options
Convertible preferred stocks are preferred shares issued to holders who may be entitled to convert their preferred shares into common stock of the company before a certain date.
Convertible bonds (or bond debentures) are debt securities that can be converted into the company’s common stock (thereby converting into equity securities).
Diluted Earnings Per Share Takeaways
So there you have it folks!
What is diluted earnings per share?
How to calculate diluted earnings per share?
A company’s diluted EPS refers to the calculation of a companies total earrings on a per-share basis assuming that convertible securities holders have exercised their rights to get common stocks of the company.
In most cases, a company’s diluted earnings on a per-share basis will be lower than the company’s regular or basic earnings per share.
The reason why the dilutive EPS is calculated is to provide a more conservative measure of a company’s financial health as compared to a company’s standard earnings per share.
I hope I was able to provide answer your questions such as what are diluted earnings per share, what does diluted EPS mean, how to calculate diluted EPS, or how does it work!
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Diluted EPS Meaning Overview And Significance
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