Basic EPS refers to a company’s Earnings per Share that are not yet adjusted the account for the effect of dilutive securities securities such as stock options, stock warrants and convertible issues. On the other hand, Diluted EPS reflect how much the company would earn on a per share basis assuming that all of its dilutive securities are exercised.
Both the Basic EPS and the Diluted EPS can be found at the bottom of the Income Statement and they reflect the profitability of the business per each share outstanding.
Investors and shareholders commonly analyze the evolution of both EPS metrics over time in order to determine if the company has been improving its performance. An upward trend on a company’s EPS indicates that it has been able to produce larger profits, and the opposite is also true.
On the other hand, a company’s EPS is affected by the number of shares outstanding. If a company has issued new shares and the Net Income remains the same, the EPS will go down.
In turn, if the company has bought back some shares and the Net Income remains unaltered, its EPS will go up. Finally, the Diluted EPS indicates the resulting EPS assuming that the company’s dilutive securities were all exercised.
Investors can use this EPS indicator to analyze the impact that dilutive securities have on the per share profitability, which affects the return on investment for existing shareholders.
Contents
Basic Earnings Per Share (EPS) is a financial metric that calculates the amount of a company’s profit allocated to each outstanding share of common stock, serving as an indicator of the company’s profitability on a per-share basis.
It is computed by dividing the net income (after dividends on preferred stock) by the total number of outstanding shares. Basic EPS provides a straightforward measure of a company’s earnings relative to its shares, helping investors gauge its financial performance and profitability.
Diluted Earnings Per Share (EPS) is a financial metric that calculates a company’s earnings per share (EPS) assuming all convertible securities, such as convertible bonds, options, and warrants, were converted into common stock.
It provides a conservative view of a company’s profitability by showing the lowest possible earnings per share if all potential shares that could dilute EPS were issued.
Diluted EPS takes into account the impact of these potential conversions and exercises on the total number of shares, offering investors insight into the potential dilution of earnings and a more comprehensive understanding of the company’s financial health.
Key Takeaways
Measurement of Profitability: Basic EPS measures a company’s profitability on a per-share basis using the current number of outstanding shares, while diluted EPS takes into account all possible shares that could be issued from convertible securities, providing a more conservative estimate of earnings per share.
Impact of Convertible Securities: Diluted EPS considers the impact of convertible securities, stock options, and warrants on earnings per share, showing how earnings would be affected if all potential shares were converted, whereas basic EPS does not account for these potential dilutions.
Investor Insight: Basic EPS offers a straightforward view of earnings allocated to each share of common stock, useful for assessing a company’s profitability. In contrast, diluted EPS provides investors with insight into the potential dilution of earnings per share, crucial for understanding the full impact of all possible securities on the company’s earnings.
The formula to calculate both the Basic EPS and the Diluted EPS are the following:
Basic EPS = (Net Income – Preferred Dividends) / Common Shares Outstanding
Diluted EPS = (Net Income – Preferred Dividends) / (Common Shares Outstanding + Effect of Dilutive Securities)
Where:
Net Income: The result of subtracting the cost of goods sold, operational expenses, financial charges and taxes from the company’s net revenues.
Common Shares Outstanding: Total common shares that are held by either individual or institutional investors.
Preferred Dividends: The total dividend paid to preferred shareholders for the time period under evaluation.
Effect of Dilutive Securities: The total number of shares that would be issued if the dilutive securities are fully exercised.
Basic EPS and Diluted EPS Examples
Black Gems is a coal mining company that operates in 5 different locations in the United States. The company is publicly traded and therefore it has to publish quarterly and annual financial statements containing the details of its operations and its financial performance.
The latest financial report issued by the company shown the following information:
(in thousands)
Net Income: $354,931
Preferred Dividends: $28,330
Common Shares Outstanding: 12,500
Stock Options: 300
Stock Warrants: 60
Each option and warrant entitles the holder to one common share of the company if the derivative is exercised.
As a result, the Basic and Diluted EPS for Black Gems would be the following:
Basic EPS = ($354,931 – $28,330) / 12,500 = $26.2
Diluted EPS = ($354,931 – $28,330) / (12,500 + 300 + 60) = $25.4
This means that the EPS would be diluted 3.1% if the dilutive shares were exercised.
Basic vs Diluted EPS Analysis
The Basic EPS and Diluted EPS track the profitability of the business on a per share basis. Investors can rely on the EPS to understand how the performance of the company has fluctuated over time regardless of the new equity it has issued.
This gives investors a clearer understanding, as the Net Income by itself could be expanded as a result of new investments but by itself it doesn’t transmit if investors are actually obtaining more money per each share they hold.
Ideally, Earnings per Share should grow in line with the additional equity investments. If a business increases its equity by 20%, its EPS should grow by at least 20% during a reasonable period of time. If the business’ EPS grows by a lower percentage the EPS will end up being lower than it was previously and investors won’t be benefited from the additional investment.
On other hand, businesses can also use leverage as a way to increase its profits without affect the company’s ownership structure or equity capital. Even though that may be reasonable under certain circumstances, taking too much debt to finance growth can increase the company’s financial risk, as any market or financial downturn can jeopardize its profitability.
The Diluted EPS will always be equal or lower than the company’s Basic EPS, as the effect of dilutive shares expand the number of shares outstanding. If a company consistently issues stock options, warrants and convertible issues, investors will be affected as the Basic EPS will be significantly diluted by these dilutive securities.
Companies usually issue these derivatives to compensate its employees or to add attractive features to certain security issues. For example, a convertible bond issue would be more attractive to investors than a straightforward bond, due to its convertibility feature.
Nevertheless, shareholders assume the cost of this convertibility and therefore, a Board of Directors that approves large volumes of dilutive securities may be acting against the shareholder’s best interest. Finally, If the company hasn’t issued any dilutive security whatsoever, the Basic EPS will be the same as the Diluted EPS for that time period.
Diluted EPS vs Basic EPS Cautions
While the Diluted EPS is a reasonable approach to estimate the effect of dilutive securities on the profitability of a business’ shares, the fact that it assumes that all the instruments will be fully exercised at the same time makes it a bit unrealistic. In reality, dilutive securities are exercised at different points in time, unless their strike price becomes very attractive for the holders.
Given the fact that companies usually issue stock options with a strike price that benefits shareholders to some extent, the effect of the dilutive securities may be lower than that shown by the Income Statement.
For example, a business could issue stock options for its executives with a strike price that’s 25% higher than the current price of the stock. If that the case, shareholders will see their EPS reduced but the price of the stock will rise significantly and they will be able to cash in through this capital gain.
Frequently Asked Questions
What distinguishes basic EPS from diluted EPS in financial reporting?
Basic EPS calculates a company’s earnings per share using the number of outstanding shares, excluding potential shares from conversions or options, while diluted EPS accounts for all possible shares that could be created from conversions, options, and warrants, providing a more conservative perspective on earnings.
How does the inclusion of convertible securities affect diluted EPS compared to basic EPS?
Convertible securities, such as convertible bonds or stock options, are included in the calculation of diluted EPS, potentially lowering the earnings per share by increasing the total share count, unlike basic EPS, which only considers current outstanding shares.
Why might an investor prefer to look at diluted EPS over basic EPS?
Investors may prefer diluted EPS as it provides a “worst-case” scenario by showing the lowest possible earnings per share if all convertible securities were exercised, offering a more comprehensive view of a company’s financial health.
Can both basic and diluted EPS be the same under certain conditions?
Yes, basic and diluted EPS can be the same if a company has no convertible securities, options, or warrants that could potentially dilute the number of shares, making both calculations result in the same value.
