What is Diluted EPS?
Diluted Earning Per Share (Diluted EPS) is a financial ratio to check the quality of the Earnings per Share after taking into account potentially dilutive securities that may increase the number of outstanding shares in the future. Calculating diluted EPS is useful when the company has a complex capital structure and contains convertible securities like Preference Shares, Stock Option, Warrants, Convertible Debentures etc
Diluted EPS Formula
Diluted EPS Formula = (Net Income – Preferred Stock Dividends) / (Weighted Average Number of Shares Outstanding + the Conversion of Any in The Money Options, Warrants and Other Dilutive Securities)
From the above-diluted earnings per share formula, you can understand you need to look at the entire balance sheet and the income statement Diluted EPS Calculation.
Steps to Calculate Diluted EPS
To find diluted EPS, start from basic EPS and then remove the adverse effect of all dilutive securities outstanding during the period.
The Diluted EPS Formula is as per below =
The adverse effects of dilutive securities are removed by adjusting the numerator and the denominator of the basic EPS formula.
- Identify all potentially dilutive securities: convertible bond, options, convertible preferred stock, stock warrantsStock WarrantsA Stock Warrant gives the holder the right to buy the company's stock at a predetermined price in a specific time period, and when the holder exercises the right, the holder buys the company's stock and the company receives the money as its source of capital., etc.
- Calculate the basic EPS. The effect of potentially dilutive securities is not included in the calculation.
- Determine the effect of each potentially dilutive security on EPS to see whether it is dilutive or anti-dilutive. How? Calculate the adjusted EPS assuming the conversion occurs. If adjusted EPS (>) basic EPS, the security is dilutive (anti-dilutive).
- Exclude all anti-dilutive securitiesAnti-dilutive SecuritiesAnti dilutive securities refer to the financial instruments initially available as convertible securities and not ordinary shares. However, converting such shares into ordinary stocks results in the higher earnings per share or an increase in shareholders' voting power. from the calculation of diluted earnings per share.
- Use basic and dilutive securities to calculate diluted EPS.
Diluted EPS Example
Let’s take an example for Diluted EPS Calculation.
Good Inc. has the following information in the year-end 2017 –
- Net Income: $450,000
- Common Shares Outstanding: 50,000
- Preferred Stock Dividend: $50,000
- Unexercised Employee Stock Options: 5000
- Convertible Preferred Stocks: 23,000
- Convertible Debt: 10,000
- Warrants: 2000
Calculate the Diluted Earnings Per Share.
All information is given in the example above. We will put it in the diluted earnings per share formula.
- First, we will find out the earnings per shareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is..
- Basic Earnings per share = Net Income / Common Shares Outstanding = $450,000 / 50,000 = $9 per share.
Diluted Earnings per Share Formula = (Net Income – Preferred Stock Dividends) / (Common Shares Outstanding + Unexercised Employee Stock Options + Convertible Preferred Stocks + Convertible Debt + Warrants)
- Or, Diluted EPS Formula = ($450,000 – $50,000) / (50,000 + 5000 + 23,000 + 10,000 + 2000)
- Or, DPS = $400,000 / 90,000 = $4.44 per share.
Colgate Diluted EPS Analysis
We note the following in Colgate’s Earnings Per Share schedule
source – Colgate 10K filings
- Basic EPS Calculation Methodology – Basic earnings per common share is calculated by dividing net income available for common stockholders by the weighted-average number of shares of common stock outstanding for the period.
- Diluted Earnings Per Share Calculation Methodology – Diluted earnings per common share is calculated using the treasury stock method on the basis of the weighted-average number of shares of common stock plus the dilutive effect of potential common shares outstanding during the period.
- Dilutive potential common shares include outstanding stock options and restricted stock unitsRestricted Stock UnitsRestricted Stock Units or RSU can be defined as stock-based compensation that is issued as company’s stock to an employee. The company establishes vesting requirements based on the performance of an individual and the length of the employment..
- Anti-dilutive securities – As of December 31, 2013, 2012, and 2011, the average number of stock options that were anti-dilutive and not included in diluted earnings per share calculations were 1,785,032, 3,504,608, and 3,063,536, respectively.
- Stock Split Adjustment – As a result of the 2013 Stock Split, all historical per share data and numbers of shares outstanding were retroactively adjusted.
How useful is diluted EPS to the investors?
- Diluted Earnings Per Share isn’t very popular among investors because it is based on a “what if” analysis. But it’s quite popular among financial analysts that want to ascertain an organization’s earnings per share at its truest sense.
- The basic assumption behind calculating diluted EPS is this – what if the firm’s other convertible securities get converted into equity shares.
- If the firm’s capital structure is complex and consists of stock options, warrants, debt, etc. along with outstanding equity shares, then diluted earnings per share must be calculated.
- Financial analysts and potential investors who are very conservative in judging the company’s earnings per share assume that all the convertible securities like stock optionsStock OptionsStock options are derivative instruments that give the holder the right to buy or sell any stock at a predetermined price regardless of the prevailing market prices. It typically consists of four components: the strike price, the expiry date, the lot size, and the share premium., warrants, debt, etc. can be converted into equity shares, and then the basic EPS would be reduced.
- Though this idea that all the convertible securities will convert into equity shares is just a fictitious one, still calculating diluted earnings per share helps a potential investor looks through all the aspects of the company’s capital structure.
Diluted EPS (Earnings Per Share) Video
This has been a guide to Diluted Earnings Per share and its meaning. Here we discuss how to calculate diluted EPS along with examples. You may also have a look at the following articles to learn more about advanced shares –