Diluted EPS – What Is Diluted Earnings per Share?
Diluted EPS is used to measure the residual net profits distributable per share if all the convertible securities of a company were exercised.
The metric used to assess the quality of a company’s earnings per share (EPS) if all convertible securities were exercised. All outstanding convertible preferred shares, convertible debentures, stock options, and warrants are convertible securities. Diluted EPS is typically lower than simple or basic EPS. However, it may actually be higher in the unusual instance of anti-dilutive securities. Only the basic EPS is reported in the financial statements in that rather rare situation. Diluted EPS is more thorough than basic EPS. It depicts the underlying shareholder value on which earnings per share are allocated. Furthermore, diluted EPS influences a company’s price to earnings (P/E) ratio as well as other valuation indicators.
When a business’s convertible securities are exercised, the Diluted EPS and basic EPS of the company are affected. The following are the most frequent dilutive or convertible securities:
- Stock options: This is a benefit provided by an employer to its employees. This is an option that, if exercised, lets an employee purchase a company’s stock at a reduced price.
- Convertible preferred stock: This refers to preferred shares of stock that can be easily converted into common shares at a later period.
- Convertible bonds: These are bonds, also known as debentures. They can be converted into a number of a company’s shares at a particular period.
How to Calculate Diluted EPS
Basic EPS is calculated by dividing the company’s net income (excluding any preferred dividends) by the number of outstanding shares. To Compute diluted EPS, simply add the number of diluted shares to the shares outstanding. This is the number of shares that would exist if all of a company’s existing potential share obligations were issued. The diluted EPS formula divides a company’s net income, excluding preferred dividends, by its entire share count, which includes both outstanding and diluted shares.
Diluted EPS Formula = (Net Income – Preferred Dividends) / SO + CDS
- EPS – Earnings per Share
- SO – Shares Outstanding
- CDS – Converted Diluted Shares
Diluted EPS – Why It Matters
Diluted EPS takes into account what would occur if dilutive securities were exercised. Dilutive securities are non-common stock securities that can be converted to common stock if the holder exercises the option. Dilutive securities, when converted, effectively increase the weighted number of shares outstanding. In turn, this lowers earnings per share (EPS).
Many companies have commitments that could result in the issuance of extra shares. For example, if a corporation grants stock options to its employees. Or, it has outstanding bonds that can be converted into common stock. In either case, extra shares may be issued. When the total number of a company’s shares increases, the value of each individual share decreases. This is a phenomenon known as dilution. As a result, it is sometimes preferable to quantify financial metrics like EPS using the “fully diluted” share count. This is the number of shares that would exist if all of these commitments were exercised.
Earnings per share measure the value of earnings per share of outstanding common stock. It is a critical metric for evaluating a company’s financial health. When companies report their quarterly and annual financial results, sales and earnings per share (EPS) are the two most widely used indicators. Only publicly traded corporations are required to publish EPS on their income statements. Companies disclose both outstanding and diluted EPS in their earnings reports. However, the emphasis is often on the more conservative diluted EPS measure. Dilutive EPS is regarded as a conservative indicator because it represents the worst-case situation for EPS.
It is improbable that everyone who owns options, warrants, convertible preferred shares, and so on will convert their shares at the same time. However, as companies continue to grow, the likelihood increases that options and warrants will be converted into common stock. A substantial gap between a company’s basic EPS and diluted EPS suggests high potential dilution for the company’s shares. Most analysts and investors find this eventuality to be undesirable. For example, consider a company that has $10 billion in outstanding shares with a $0.10 difference between its basic and diluted EPS. While $0.10 may appear tiny, it translates to $1 billion in value that investors do not have access to.
Interpreting Diluted EPS – Higher or Lower?
Generally, the larger the net dilutive impact of convertible securities, the greater the downward pressure on the diluted EPS figure and the value of the firm. As a result, higher diluted EPS values, in general, should result in higher market valuations if the company. This assumes a mature company with a track record of profitability. Therefore, investors are more willing to pay a premium for each share of ownership. The market will generally assign higher valuations to prominent firms with larger net profits and expected EPS. This applies to firms with the potential to attain higher net profits someday. For example, promising startup companies with future upside and margin growth.
As a result, companies earlier in their lifecycles can receive considerably higher valuations. This is despite having poor profit margins or even being initially unprofitable. It depends on the market’s conviction that the company will eventually become profitable. Higher EPS can be an accurate indicator that the company is generating higher quality free cash flows at higher margins. Especially, when dilutive securities are appropriately adjusted for. A rise in FCFs directly results in additional cash that can be spent to boost growth. Also, for improving the defensibility of present market share and fending off smaller players or new entrants.
Example of Diluted Earnings per Share
Dilutive securities include convertible preferred stock, stock options, and convertible bonds. Convertible preferred stock is a preferred share that can be readily converted to a common share. A common employee benefit given to employees is the right to purchase company stock options. These options give the buyer the opportunity to purchase common stock at a predetermined price within a predetermined period. Convertible bonds are similar to convertible preferred stock. Both are convertible to common stock at the prices and timeframes indicated in their contracts. If all of these securities were exercised, the number of shares outstanding would increase. However, earnings would not change resulting in a decrease in EPS.
For example, suppose a business had $100 million in net income for its most recent fiscal year with no preferred dividends. The company has 20 million shares outstanding. The basic EPS calculation would be:
EPS = $100 million ÷ 20 million = $5.00/share
Calculating Diluted EPS
Diluted earnings per share adjust the basic EPS figure by accounting for all potential dilution. It generally results in reported earnings per share being lower than they would have been if triggered at current prices and conditions. Consider the above example but with potential stock options granted to the employees. Employee stock options result in the issuance of five million more shares that have yet to be exercised. This is in addition to the basic EPS example’s average outstanding share count of 20 million shares. The diluted EPS calculation would then be as follows:
Diluted EPS = $100 million ÷ ((20 million + 5 million) = $4.00/share
Diluted Earnings Per Share is not widely used by investors because it is predicated on a “what if” scenario. However, it is quite popular among financial analysts. Their goal is to determine an organization’s earnings per share in its most accurate form. At the very least, investors must understand which EPS figures will be reported on public financial statements. Clearly, it matters in specific instances when using either approach. Knowing the difference between basic and diluted EPS can give an edge to an informed investor. It always helps you make use of all the information available when selecting your next opportunity.
Asiana Airlines to raise 100 billion won — approx. US$94 million — by issuing convertible bonds with a five-year maturity. Domestic institutional investors are scheduled to buy the debt on 13 April 2018, with the maturity on 13 April 2023. The debt can be converted into 20 million shares in the airline, beginning on 13 April 2020. Asiana plans to reduce its debt-to-equity ratio with the capital raised via the issuance. The expected net profit for 2018 is 254.5 billion won. (Source: aviator.aero)
Up Next: What Is an Intentionally Defective Grantor Trust (IDGT)?
An intentionally defective grantor (IDGT) trust is an estate-planning strategy used to freeze an individual’s assets for estate tax purposes but not for income tax purposes. The intentionally defective grantor trust is set up as a standard grantor trust, but with a loophole. The deliberate defect allows the trustor to continue paying income taxes on certain trust assets. This is even after the assets have been transferred away from the individual. A properly established IDGT is treated as separate from the grantor for federal estate and gift tax reasons. However, it is treated as owned by the grantor for federal income tax purposes. In other words, income tax laws do not recognize that those assets have been transferred away from the individual.