What is diluted earnings per share (EPS)?

Diluted earnings per share (EPS) is a metric that measures a company's profitability per share, considering all potential shares that could be created through the conversion of convertible securities, such as stock options, warrants, and convertible bonds. 

EPS provides a more comprehensive view of a company's earnings per share by accounting for the potential dilution of existing shares. 

What does dilution mean? 

Dilution happens when a company issues more shares of its common stock, which reduces the ownership percentage and earnings per share of existing shareholders.

Dilution is the reduction in the ownership percentage or earnings per share of existing shareholders when a company issues new shares. Dilution can occur for various reasons, such as raising capital, issuing stock options, or acquiring other companies and can affect the voting power, control, and value of existing shares.

Diluted EPS vs. basic EPS

Diluted EPS and basic EPS are two different ways of calculating EPS. Let’s first go over dilutive securities. These are financial instruments that can be converted into common shares in the future, such as stock options, warrants, convertible bonds, and convertible preferred stocks.

• Basic EPS assumes that no dilutive securities are exercised or converted into common shares. It uses the actual number of common shares outstanding as the denominator.
• Diluted EPS assumes that all dilutive securities are exercised or converted into common shares and uses the adjusted number of common shares outstanding as the denominator. It is always equal to or lower than basic EPS because it reflects the potential reduction in EPS due to the increase in the total number of common shares.

What is anti-dilution?

Anti-dilution is the protection that some shareholders, especially preferred shareholders, have against dilution. Anti-dilution clauses allow these shareholders to adjust the conversion ratio of their preferred shares to common shares when new shares are issued at a lower price than the original price. 

Dilution vs. anti-dilution

Dilution and anti-dilution are important concepts in corporate finance and venture capital because they affect a company's valuation and ownership structure. 

Dilution can benefit a company by raising more capital, attracting talent, and facilitating growth, but it can also harm existing shareholders by lowering their stake and earnings. 

Anti-dilution can protect some shareholders from losing value but can also create conflicts of interest and discourage new investors. 

Why use diluted EPS?

Diluted EPS is useful for comparing the earnings performance of different companies, especially if they have different capital structures or financing sources that could affect the number of outstanding shares. 

Diluted EPS also reflects the potential impact of dilutive securities on earnings per share and the company's value. Diluted EPS can help investors assess the risk of investing in a company and the likelihood of future dividends or share repurchases.

What do diluted earnings per share tell investors?

Diluted earnings per share is important for investors because it reflects the potential dilution of their ownership stake in a company due to the conversion of convertible securities.

They also indicate how much a company is earning from its core operations, as it excludes the impact of non-recurring items (e.g., extraordinary gains or losses, discontinued operations, or accounting changes).

Diluted earnings per share help investors evaluate a company's growth potential because they show how much the EPS figure would change if the company were to issue more shares or exercise its stock options.

What's a good diluted EPS? High vs. low diluted EPS

High degree of dilution: If the diluted EPS is significantly lower than the basic EPS, it means that the company has a high degree of dilution, which could reduce the value of the existing shares and the future earnings per share.

Low degree of dilution: If the diluted EPS is close to or higher than the basic EPS, it means that the company has a low degree of dilution, which could increase the value of the existing shares and the future earnings per share.

Now, what does all of that mean? To translate that, if the diluted EPS is higher than the industry average, it means that the company is more profitable and efficient than its peers, which could attract more investors and drive up the share price.

If the diluted EPS is lower than the industry average, it means that the company is less profitable and efficient than its peers, which could deter investors and drive down the share price.

Which types of companies should report diluted EPS?

According to accounting standards, all publicly traded companies that have dilutive securities outstanding should report both basic and diluted EPS on their income statements. 

Private companies that have dilutive securities outstanding may also report diluted EPS, but they are not required to do so.  If they do not have any dilutive securities outstanding, they do not need to report diluted EPS, as their basic and diluted EPS would be the same. Private companies that typically report diluted EPS are technology  and biotech companies, start-ups, and companies that use stock-based compensation or have convertible debt.

Diluted EPS formula and calculation

EPS formula

The basic formula for calculating EPS is:

EPS = Net Income / Weighted Average Number of Common Shares Outstanding

Suppose that a company’s net income is $10 million for the year 2024, and it has 5 million common shares outstanding at the beginning of the year, and 6 million common shares outstanding at the end of the year. 

The weighted average number of common shares outstanding for the year 2024 is:

Weighted Average Number of Common Shares Outstanding = (5 million + 6 million) / 2 = 5.5 million

Therefore, the basic EPS for the year 2024 is:

EPS = $10 million / 5.5 million = $1.82

This means that the company earned $1.82 for each share of common stock in 2024.

Diluted EPS formula

The diluted EPS calculation is:

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

The steps to calculate diluted EPS are:

• ‍Determine the net income attributable to common shareholders by subtracting the preferred dividends from the net income. ‍
• Determine the preferred dividends. These are the dividends paid to preferred shareholders.‍
• Determine the weighted average number of common shares outstanding by multiplying the number of common shares outstanding at the beginning and end of the period by the fraction of the period they were outstanding, and then adding the results. The weighted average reflects the changes in the number of common shares during the period.‍
• Determine the dilutive common shares by applying the if-converted or the treasury stock method to each type of dilutive security.‍
  • The if-converted method assumes that all the convertible securities are converted into common shares at the beginning of the period or the date of issuance, whichever is later. 

It reflects the impact of the conversion on the issuer's income statement and balance sheet, as it eliminates the interest expense and the debt liability related to the convertible bonds and increases the number of shares outstanding and the equity capital. 

• The treasury stock method assumes that the proceeds from the exercise of stock options or the conversion of convertible securities are used by the company to buy back its own shares at the average market price.

It is only used when the stock options or convertible securities are in the money, meaning that their conversion or exercise price is lower than the average market price of the common stock.

• ‍Add the weighted average common shares and the dilutive common shares to get the denominator of the diluted EPS formula.‍
• Divide the net income attributable to common shareholders by the denominator to get the diluted EPS.

Diluted earnings per share calculation example

Let's assume that a company has the following financial data for the year 2024:

• Net income: $50 million
• Preferred dividends: $10 million
• Common shares outstanding: 200 million
• Potential shares from stock options and convertible bonds: 50 million

The formula for diluted EPS is:

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

Step 1: Calculate the numerator

$50 million - $10 million

=$40 million 

Step 2: Calculate the denominator 

200 million + 50 million

= 250 million

Step 3: Apply the diluted EPS formula

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

= $40 million / 250 million

= 0.16 per share

The diluted EPS in this example is $0.16 per share.

Diluted EPS ratio calculation example

Assume a company has the following financial data:

• Net income: $100 million
• Preferred dividends: $10 million
• Weighted average shares outstanding: 200 million
• Employee stock options that could convert to 50 million shares
• Convertible bonds that could convert to 150 million shares

Step 1: Calculate the numerator

Net income - Preferred dividends 

= $100 million - $10 million 

= $90 million

Step 2: Calculate the denominator 

Weighted average shares outstanding + Potential dilutive shares

= 200 million + 50 million + 150 million 

= 400 million shares

Step 3: Apply the diluted EPS formula

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

= $90 million / 400 million shares

= $0.225 per share

The diluted EPS ratio in this example is $0.225 per share. This shows the earnings per share if all convertible securities and stock options were exercised, providing a more conservative view of the company's per-share profitability compared to basic earnings per share.

FAQs about diluted earnings per share

What is the difference between basic and diluted EPS?

The main difference between basic and diluted EPS lies in the consideration of potential dilution from convertible securities. Basic EPS provides a straightforward measure of profitability, while diluted EPS offers a more rigorous assessment by considering the potential decrease in earnings per share due to the conversion of other securities.

Is EPS or diluted EPS better?

There is no definitive answer to which one is better, as both EPS and diluted EPS have their advantages and limitations. 

EPS shows the actual earnings per share that the company reported in a given period, which reflects its historical performance and profitability. Diluted EPS shows the potential earnings per share that the company could have reported if all the potentially dilutive securities were converted into shares, which reflects its future performance and risk.

Why is diluted earnings per share important?

Diluted EPS is important for investors and analysts because it provides a more conservative and realistic estimate of a company's earnings per share than basic EPS, which only considers the actual number of common shares outstanding. 

Diluted EPS reflects the potential impact of dilutive securities on the company's earnings and share price, and thus gives a better indication of the company's future earnings potential and valuation.

What does a higher earnings per share indicate?

A higher EPS indicates that the company is generating more profits for its shareholders. It also implies that the company has a competitive advantage, a strong market position, or a unique value proposition.

A higher EPS can boost the company's stock price, as it reflects the market's confidence in the company's future prospects. It can also increase the company's dividend payouts, as it indicates that the company has enough cash flow to reward its investors.

What is a good diluted earnings per share?

Generally, a good diluted EPS is one that is positive, consistent, and growing over time. It indicates that the company has a sustainable business model, a loyal customer base, and a competitive edge.

What does a negative diluted EPS mean?

A negative diluted EPS means that the company is losing money and has a negative net income. It also means that the company is not generating enough cash flow to cover its expenses, debt obligations, or dividend payments.

A negative diluted EPS can indicate that the company is facing financial difficulties, operational challenges, or strategic issues. Or, it can signal that the company is undergoing a restructuring, a turnaround, or a transformation.

A negative diluted EPS can affect the company's stock price and credit rating, as it reflects the market's pessimism about the company's future performance and that it has a higher default risk.

Why is diluted EPS only calculated for profitable companies?

Diluted EPS matters when there's profit to spread around. If there's no profit, it doesn't make sense to calculate how thinly you'd spread it. That’s why it’s only calculated for profitable companies. 

Diluted EPS shows how much profit each share would get if all potential new shares were created. For companies losing money, investors are more focused on whether the company can make money at all.

Conclusion: Rho helps you manage your finances, and profits, better

Diluted EPS measures a company's profitability per share, factoring in potential dilution from convertible securities like stock options and bonds. By providing a clearer picture of earnings available to shareholders, it helps investors assess the impact of potential share increases on their investments.

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Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.

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