The diluted earnings per share of a company is a vitally important financial tool for analysts and investors. It is a more realistic calculation for the true EPS of a company and is more useful in determining a valuation of its share price. Just looking at the basic EPS of a company could result in a misleading impression about the value of a company's stock price.
What Is Diluted EPS?
Companies regularly report their net income and basic earnings per share on their income statements. This basic EPS is a straightforward calculation found by dividing total net income by the number of common shares outstanding. However, the basic EPS can be deceptive because of the composition of the company's debt instruments and employee incentive plans.
Companies use a variety of debt instruments and different classes of shares to finance their operations. Some of these financial instruments are convertible securities that can be converted to shares of common stock under certain conditions. The purpose of calculating the diluted EPS is to find the possible effects of these convertible securities on the basic EPS.
Diluted EPS is a financial formula used to evaluate the quality of a company's earnings per share if all of its convertible securities were exercised. Examples of convertible securities are stock options, convertible preferred shares, warrants and convertible debentures.
How Is Diluted EPS Calculated?
A company's diluted EPS is calculated by taking total net income, subtracting preferred dividends and dividing by the weighted average number of fully diluted outstanding common shares.
The formula is as follows:
Diluted EPS = (net income - preferred dividends)/(weighted average number of shares outstanding + conversion of all in-the-money options, warrants + all other convertible securities)
In-the-money means the strike price of the option is below the current market price. Convertible securities that are in-the-money have the potential to dilute the earnings per share if they are converted. Securities that are out-of-the-money are considered anti-dilutive since they would not be converted and would, therefore, not have any effect on the number of common shares outstanding.
What Is the Difference Between Basic and Diluted EPS?
When a company has convertible securities in its debt structure, the diluted EPS will always be less than its basic EPS. A significant difference between a company's basic EPS and its diluted EPS means that the company has numerous securities that could be converted to shares of common stock.
Consider a business that had a net income of $200,000 and had 40,000 shares of outstanding common stock. Its basic EPS would be $5.00 per share: EPS = $200,000/40,000
Now, suppose this company had a convertible security that could, if converted, result in the creation of an additional 5,000 shares of common stock. The diluted EPS would be $4.44: $200,000/45,000
What Is the Significance of Diluted EPS?
The reason to calculate the diluted EPS is that the basic EPS could misrepresent the actual earnings per share that a common shareholder could receive if all dilutive securities are converted.
The diluted EPS affects a company's price to earnings ratio and other metrics used to establish a value for the firm. For example, apply a P/E ratio of 15 times to the basic EPS and diluted EPS from the example above.
Using the basic EPS would project a share price of $75: $5.00 X 15 = $75
The diluted EPS results in a share price of $67: $4.44 X 15 = $67
The difference in these two share prices can affect investors' buy-sell decisions and management's ability to raise more outside capital.
Calculating the diluted EPS of a company is an important exercise to determine the actual earnings of a company. The amount and potential dilution of convertible securities must be considered to arrive at a realistic valuation of the company's stock.