Diluted EPS

Investors and analysts use diluted EPS to evaluate an investment proposal and its subsequent performance, while Earnings per share (EPS) gauges the company's performance. It measures the company's net income divided by the outstanding number of shares. Diluted EPS share price dives further and considers the future share obligations of the company. 

But what is diluted EPS? This article will discuss diluted EPS, its importance, and its calculation.
 

What is diluted EPS?

Diluted earnings per share is a financial metric that shows the net income a company generates for each share of its common stock outstanding, where all convertible securities, such as options, warrants, and convertible preferred stock, are considered. 

Diluted EPS share price considers the maximum potential dilution of a company's earnings per share, which occurs when all potentially dilutive securities are exercised or converted into common stock. It is essential for investors and analysts as diluted EPS accurately depicts a company's profitability by incorporating the effect of potential dilution on earnings per share.

Calculating diluted EPS involves taking the company's net income and subtracting any preferred stock dividends, then dividing it by the cumulative number of shares outstanding, including all dilutive securities. It is a more comprehensive measure of a company's earnings per share than plain EPS since it considers the number of outstanding shares. 

Understanding diluted EPS

Diluted EPS calculation considers how much net income is generated for each share of common stock outstanding if all potentially dilutive securities are converted into common stock. 

Diluted EPS is often lower than plain EPS, which only considers outstanding common shares, thus depicting an accurate picture of a company's profitability. Investors can use it to make an informed investment decision and compare companies with varying capital structures.

Importance of Diluted Earnings Per Share
Having discussed the Diluted EPS meaning, let us understand its importance. It is helpful to investors, as this metric helps them understand a company's actual earnings per share. Companies with convertible securities, such as stock options or convertible bonds, can experience dilution in their earnings per share if those securities may convert into common shares.

Diluted EPS share price is a good indicator of a company's financial health, considering the potential dilution from these securities. A high diluted EPS means the company generates many earnings per share. Analysts also use it to compare a company's EPS to its competitors.
 

Formula and calculation of diluted EPS

The diluted EPS formula is as follows:

Diluted EPS = (Net income - Preferred dividends) / (Weighted average shares outstanding + Dilutive securities)

The numerator in the equation is the company's net income minus any dividends paid to preferred shareholders. The diluted EPS formula reduces preference dividends from net income. The focus is on calculating the Earnings Per Share (EPS) for common shareholders.

The denominator is the weighted average of outstanding shares, including the common shares and dilutive securities, such as stock options or convertible bonds. To calculate the weighted average number of shares outstanding, we need to consider the number of shares outstanding during each reporting period and multiply it by the number of days it was outstanding. Then it is divided by the total number of days in the reporting period.

Calculating diluted EPS requires a thorough understanding of the company's capital structure and the potential impact of convertible securities on its earnings. 
 

Example of diluted EPS

Let's understand with the help of a diluted eps example. A company with a net income of Rs. 100,000, paid Rs. 20,000 in preferred dividends, has 100,000 common shares outstanding, and has 20,000 stock options outstanding with an exercise price of Rs.10 per share. The market price of the company's stock is Rs.20 per share. 

The basis EPS of the company is Rs. 100,000 / 100,000 = Re. 1 per share.  The diluted EPS calculation would be as follows.

Diluted EPS = (Rs.100,000 - Rs.20,000) / (100,000 + (20,000 * (Rs.20 / Rs.10))) = Rs.0.78 per share. 

This calculation shows the company's diluted earnings per share would be Rs.0.78, considering the potential dilution from the outstanding stock options.
 

Diluted EPS vs EPS

The key difference between diluted EPS and plain EPS is that the former accounts for the potential dilution from outstanding convertible securities, while plain EPS does not. Basic EPS calculates the dilution by dividing net income by the number of outstanding shares. In contrast, diluted EPS considers the potential dilution from convertible securities and adjusts the number of outstanding shares accordingly.

A company reports its EPS on the income statement; only public companies must include it in their earnings reports. Public companies report both primary and diluted EPS, but the focus is often on the conservative diluted EPS measurement.
 

Why do investors and analysts calculate diluted EPS?

After understanding the diluted EPS formula with an example, convertible securities, such as stock options or convertible bonds, can potentially increase the number of outstanding shares, diluting the earnings per share for existing shareholders. By calculating diluted EPS, investors and analysts can better evaluate a company's financial health, potential growth, and profitability and make more informed investment decisions. 

Investors typically use diluted EPS alongside other financial ratios and metrics. Additionally, some companies may use stock-based compensation to attract and retain employees, making diluted EPS an important metric for evaluating the impact of such compensation plans on shareholder value.
 

Breaking down the numerator – Net income and preferred dividends

The numerator in the calculation of diluted EPS includes the net income available to common shareholders after adjusting for any preferred dividends paid. The company prioritises paying preferred dividends over other dividends to common shareholders. Usually, the preferred dividend is paid off at a fixed rate on the issued share capital. 

Preferred dividends are paid to preferred shareholders and must be subtracted from net income when calculating diluted EPS because they reduce the income available to common shareholders.
 

Should you use fully diluted shares outstanding?

When calculating diluted EPS, companies can use either basic or fully diluted shares outstanding. Basic shares outstanding include only the currently outstanding ones. In contrast, fully diluted ones, that are outstanding include all potential shares that may convert into common shares, such as stock options, warrants, or convertible bonds. 

Fully diluted shares outstanding provide a more precise representation of the potential earnings per share and are helpful when calculating diluted EPS. However, some argue that the fully diluted number of outstanding shares is a more conservative approach. Some options may be far from the money and never convert into shares. 
 

What does a diluted EPS tell shareholders?

Diluted EPS evaluate the effect of the exercise of dilutive securities on the earning per share of a company. By itself, dilutive securities are not considered common stock. However, the company is obligated to convert it into common stock if the holder exercises that option. On conversion, dilutive securities increase the weighted number of outstanding shares. Consequently, it decreases the EPS and devalues a shareholder's equity stake.

One falling of EPS dilution is that it does not consider dilutive effect stock options. Many companies tend to exclude stock options in a company's diluted EPS calculation. Another disadvantage of Diluted EPS calculation is that it does not capture the impact of dilutive securities on a company's cash flow. Dilutive securities can significantly impact a company's cash flow, not captured in diluted EPS calculation.

Is a high diluted EPS better than a low diluted EPS?

A high diluted EPS indicates that a company is generating strong earnings per share, which can be a positive sign for investors. However, a high diluted EPS does not necessarily mean a company is a good investment. When evaluating potential investments, investors should also consider other factors, such as a company's growth potential, financial stability, and management team.

What types of companies report diluted EPS?

Companies report diluted EPS by companies with outstanding securities that may convert into common shares, such as stock options, convertible bonds, or convertible preferred shares. Most publicly traded companies report diluted EPS in their financial statements, which is considered a standard metric for evaluating a company's earnings potential.

Some private companies may choose to report their diluted EPS. However, private companies don't need to do so. 
 

Conclusion

Diluted EPS is a financial parameter that shows a company's profit quantum for each share of its stock. It is a factor of the company's net income and the number of common and dilutive shares outstanding. 

Dilutive securities give the holder the right to convert the underlying security into common shares of a company's stock at a predetermined price. Diluted EPS can be used to compare companies' profitability or assess a company's financial performance over time.