What is Diluted Earnings Per Share?
Definition: Diluted earnings per share (EPS) is the income that a shareholder would earn from every individual share of a company in the event of exercising of all convertible securities like warrants and options. When calculating the diluted EPS, accountants assume that holders of all convertible securities will actually exercise them during that particular accounting period. Some of the securities that are dilutive to EPS when they are converted include stock options, convertible preferred shares, bonds that are convertible, warrants and so on.
Public companies have an obligation to give good returns to their shareholders. That is why shareholders may hire financial analysts to appraise the profit potential of the company. During analysis, certain things like diluted earnings per share might come up. This article defines, defines and explains diluted earnings per share.
Usually, investors want to know the most accurate value they will earn for holding the shares of a public company. Therefore, the analyst is under obligation to consider all scenarios including the worst-case scenario. While the basic earnings per share (EPS) is enough for a company that has common share outstanding only, computation of the diluted EPS is necessary for companies that have different types of stock apart from common stock.
Why is it Important to Calculate the Diluted EPS?
To grasp the significance of calculating the diluted EPS, you should first understand basic EPS. Basic EPS simply evaluates the size of profits that a company earned for every single share during an accounting period. This is simply calculated by dividing the net income of the company during the accounting period by the total number of common shares that the company issued over that period.
Nevertheless, since the basic EPS evaluates the profit that common shareholders would earn, an analyst must adjust the net income by subtracting preferred dividends from it. This is because companies pay out preferred dividends before calculating the EPS. Therefore, this expense reduces the price of the individual share.
Any dilutive item is that which reduces the basic EPS. As such, diluted EPS captures all items in the company’s capital framework that would dilute the basic EPS. The fact that basic EPS does not capture the dilutive elements means that it is likely to overstate the amount of profit that common shareholders might earn for the accounting period. Therefore, the diluted EPS is a more accurate representation of the profit to which common shareholders are entitled.
Diluted EPS Formula
Calculating diluted EPS follows the same procedure as basic EPS. All you need is the net income and the shares outstanding. The only difference is that you must adjust the shares outstanding by taking in account all dilutive elements. As such, the diluted earnings per share formula is calculated like this:
Diluted EPS = (Net Income – Convertible Preferred Dividends) / (Weighted Average Shares Outstanding (WASO) + All dilutive items)
The net income includes the profit or loss that the company can attribute to common shareholders of the company. You can adjust the net income further by adding the after tax interest that is attributable to convertible debt.
Company Theta earns a net income of $255,000, and it has common shares outstanding amounting to 1,500,000 whose market price $10 each. The company extends 100,000 outstanding options to key employees exercisable at a strike price of $8 each.
Note: Company Theta does not offer preferred dividends.
Here is how we calculate the diluted EPS of Company Theta.
Calculate the number of shares outstanding that would have been purchase were the stock options outstanding converted.
- There were 100,000 stock options with a strike price of $8 each. Hence their total value is 100,000 x 8 = $800,000.
- If the stock options were exercise, the following number of shares would have been purchase = $800,000 ÷ $10 = 80,000.
Find the extra shares that would be dilutive to the EPS
- Subtract the number of shares that would have been purchased if the stock options were converted from the stock options = 100,000 – 80,000 = 20,000. The 20,000 is the incremental outstanding shares.
Step 3: Calculate the diluted EPS
Diluted EPS = 255,000 ÷ (1,500,000 + 20,000) = 255,000 ÷ 1,520,000 = $0.17.
= $0.17.