Definition: Diluted earnings per share, also called diluted EPS, is a profitability calculation that measures the amount of income each share will receive if all of the dilutive securities are realized. In other words, it shows the effect of dilutive securities like stock options, rights to purchase common shares, bond and preferred stock that can be converted to common shares on the basic earnings per share.
The basic earnings per share formula takes the difference between net income and preferred dividends and divides it by the average outstanding common stock. This calculates the amount of income that is available to the current common shareholders of the company. The key word in that sentence is current. It only reflects the current outstanding shares.
What Does Diluted EPS Mean?
What is the definition of diluted earnings per share? Diluted EPS is more detailed than EPS as it portrays the true shareholder value based on which the earnings per share are allocated. Furthermore, the diluted EPS affects a firm price to earnings (P/E) ratio as well other valuation measures. To calculate the diluted EPS, we need to know the net income, the preferred dividends, the convertible preferred dividend, the tax rate, the weighted average of dilutive common shares, the convertible preferred shares, the convertible debt and the unexercised employee stock options. Compared to the EPS, the diluted EPS is always lower.
Dilutive securities are not current outstanding shares, but they do have the possibility of becoming outstanding shares. Although the possibility of all of the dilutive securities being called at once is impossible, it would drastically reduce the basic earnings per share because the number of outstanding shares would skyrocket.
That is why the diluted earnings per share calculation is often calculated in the notes of the financial statements. This shows investors and creditors what would happen if all the stock options and conversions were turned into common shares overnight. It also shows the capital structure of the organization.
Large amounts of options and preferred shares show the business requires a more complex capital structure to fund its operations and expansions. This could be a good or bad thing depending on what investors and creditors expect in an industry.
The diluted earnings per share formula uses the basic EPS calculation and adds the dilutive securities to the common shares in the denominator.
Example
The net income of company ABC is $4,000,000. In the beginning of 2015, the company had 3,000,000 shares outstanding, but in the second half, the shares outstanding increased to 4,200,000. Furthermore, the company has unexercised employee stock options = $250,000, convertible preferred shares = $100,000, convertible debt = $125,000, convertible debt dividend = $20,000, and preferred dividends = 0. The tax rate is 35% and the interest is $5,000 annually.
John works as a financial analyst in the company ABC and is asked to calculate the diluted EPS and compare it to the EPS.
The first step is to calculate the weighted average of dilutive common shares, which is the product of the outstanding shares multiplied by the weight of the reporting period. In this case, the first half of the year was covered by 5,000,000 shares outstanding and the second half of the year was covered by 6,200,000 shares outstanding. Therefore, the weighted average of the dilutive common shares is (0.5 x 3,000,000) + (0.5 x 4,200,000) = 1,500,000 + 2,100,000 = 3,600,000.
Now, John can calculate the firm’s diluted EPS as follows:
Diluted EPS = (net income – preferred dividend) + convertible preferred dividend + (convertible debt interest x (1-t)) / weighted average of dilutive common shares + unexercised employee stock options + convertible preferred shares + convertible debt.
$4,000,000 + $20,000 x (1-35%) / 3,600,000 + 250,000 + 100,000 + 125,000 = $4,000,000 + $13,000 / 4,075 = 0.98.
Compared to the firm’s EPS of 1.3, the diluted EPS is lower to allow a better dilution of earnings over the shareholder value.
Summary Definition
Define Diluted EPS: Diluted EPS measures a firm’s earnings performance, if the firm’s unexercised employee stock options, convertible preferred shares, convertible debt, and warrants are exercised.
