One measure used to gauge a company’s profitability is earning per share. It looks at a company’s net income relative to their total shares outstanding. Diluted earnings per share is a similar measure, but it also factors a company’s dilutive securities that can be issued in the future. What are dilutive securities? Securities that can be converted into common shares – which are stocks that sometimes pay dividends and often give shareholders voting rights. Diluted shares can include both convertible bonds and employee stock options.
When a business converts dilutive securities, it can lead to an increase in the number of shares outstanding. Assuming the company’s earnings stay the same, converted dilutive securities can lead to lower earnings per share. This is significant seeing as the higher a company’s EPS, the more profitable it’s said to be. That said, diluted EPS can be a more accurate measure of a company’s profitability.
Calculating Diluted EPS
The goal of an EPS calculation is to see what the EPS would be if dilutive shares are converted to common shares. To calculate a company’s diluted EPS, you take its net income and subtract preferred stock dividends. You then divide that number by the company’s average outstanding shares and finally, subtract the dilutive shares. Here is an equation below.
Diluted EPS = (Net Income – Preferred Stock Dividends)/(Average outstanding Shares + Diluted Shares)
Example of Diluted EPS
Let’s say a company makes $10,000,000 in net income, has $2,000,000 preferred stock dividends, and $2,000,000 outstanding shares. In addition, they have one million shares of employee stock options.
- Net income: $10 million
- Preferred stock dividends: $1,500,000
- Outstanding shares: $18 million
- Employe stock options: (Dilutive shares): $7 million
- Convertible bonds: $12 million
The diluted EPS would be $0.23.
EPS = $10,000,000 – $1,500,000 / $18,000,000 + $19,000,000
To calculate the diluted EPS, you would simply remove the diluted share from the equation and end up with the following:
Net income – preferred dividends / average outstanding common shares = EPS
In this case, the EPS would be $0.47, which is higher than the diluted EPS. The EPS calculation is higher than the diluted EPS equation because it doesn’t include the dilutive shares.
EPS vs. Diluted EPS
While EPs and diluted EPS have similar goals-to give insight to how profitable a company is, both measures do it in different ways. Earnings per share only counts existing common shares. On the other hand, diluted EPS factors in common shares and dilutive shares that could potentially be sold in the future. As a result, the EPS is usually a higher number than diluted EPS.
The difference between EPS and diluted EPS when it comes to the calculation is that the latter adds the number of dilutive shares to the number of average outstanding shares.
Diluted EPS in Investing
Before investing in a company, it can be helpful to know the diluted EPS to get a clearer picture about how profitable a company is. This information can also be helpful to know even for companies an investor already has shares in. When a company converts dilutive shares, it can lead to existing shares becoming diluted or worth less.
On the other hand, a higher EPS can indicate a healthy company with abundant free cash flow. When companies have a high diluted EPS, investors may be willing to pay more per share. If an investor is unsure whether a company is worth investing in, they can seek the help of a financial advisor.
