What is Diluted EPS?
Diluted EPS is a financial ratio to check the quality of the Earnings per Share after taking into account the exercise of Convertible Securities like Preference Shares, Stock Option, Warrants, Convertible Debentures etc.
Let us have a look at the Colgate Palmolive Earnings Per Share Schedule. We note that there are two variations of EPS – Basic EPS and Diluted EPS in Colgate. Please note – we have already discussed EPS and Basic EPS in another article.
What is the Effect of Dilutive Securities on EPS?
To find diluted EPS, start from basic EPS and then remove the adverse effect of all dilutive securities outstanding during the period.
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, warrants, 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 securities from the calculation of diluted earnings per share.
- Use basic and dilutive securities to calculate diluted EPS.
#1 – Effect of Convertible Debt on Diluted earnings per share
Effect on Numerator
Upon conversion, the numerator (net income) of the basic EPS formula increases by the amount of interest expense net of a tax associated with those increased by the amount of interest expense, net of a tax associated with those potential common shares. Why? If converted, there would be no interest in the bond, so income available to common shares will increase accordingly. After-tax interest is used because bond interest is tax-deductible while net income is calculated on an after-tax basis.
Effect on Denominator
Upon conversion, the denominator (weighted average number of shares outstanding) of the basic EPS formula increases by the number of shares created from the conversion, weighted by the time that these shares would be outstanding: number of shares due to conversion = par value of the convertible bond/conversion price.
Before calculating diluted EPS, one needs to check if this security is anti-dilutive. To check whether the convertible debt is anti-dilutive, calculate
If this number is less than basic EPS, convertible debt is dilutive and should be included in the calculation of diluted EPS
Effect of Convertible Debt
During 2006, KK Enterprise reported a net income of $250,000 and had 100,000 shares of common stock. During 2006, KK Enterprise issued 1,000 shares of 10%, par $100 preferred stock outstanding. In 2006 KK Enterprise issued, at par, 600, $1,000, 8% bonds, each convertible into 100 shares of common stock. Calculate diluted earnings per share Assume tax rate – 40%
DILUTED EPS CALCULATION
#2 – Effect of Convertible Preferred Stock
Effect on Numerator
Upon conversion, the numerator of the basic EPS formula would increase by the amount of the preferred dividends. If converted, there would be no dividends for the convertible preferred stock so income available to common shares will increase accordingly. Different from bond interests, preferred dividends are not tax-deductible.
Effect on Denominator
Upon conversion, the denominator of the basic EPS formula would increase by the number of shares created from the conversion, weighted by the time that these shares would be outstanding: number of shares due to conversion = number of convertible preferred shares outstanding x conversion rate. The time outstanding would be the entire year if the preferred stock was issued in a previous year, or a fraction of the year if the preferred stock is issued in the current year.
Before calculating diluted earnings per share, one needs to check if this security is anti-dilutive
To check whether the convertible preferred stock is anti-dilutive, calculate
If this number is less than basic EPS, a convertible preferred stock is dilutive and should be included in the calculation of diluted EPS
Effect of Convertible Preferred Stock
During 2006, KK Enterprise reported a net income of $250,000 and had 100,000 shares of common stock. During 2006, KK Enterprise issued 1,000 shares of 10%, par $100 preferred stock outstanding, each convertible into 40 shares. Calculate diluted EPS. Assume tax rate – 40%
DILUTED EPS CALCULATION
#3 – Options and Warrants
Treasury Stock method is used to calculate the impact of dilutive securities like Options and Warrants.
This method assumes that the options and warrants are exercised at the beginning of the year (or date of issue if later) and the proceeds from the exercise of options and warrants are used to purchase common stock for the treasury. There is no adjustment to the net income in the numerator.
Below are the 3 primary steps used for Treasury Stock Method
Treasury Stock method formula for Net Increase in number of shares
- If the exercise price of the option or warrants is lower than the market price of the stock, dilution occurs.
- If higher, the number of common shares is reduced and the anti-dilutive effect occurs. In the latter case, exercise is not assumed.
Effect of Options / Warrants
During 2006, KK Enterprise reported a net income of $250,000 and had 100,000 shares of common stock. During 2006, KK Enterprise issued 1,000 shares of 10%, par $100 preferred stock outstanding. In addition, the company has 10,000 options with a strike price (X) of $2 and the current market price (CMP) of $2.5. Calculate diluted EPS.
Assume tax rate – 40%
BASIC EPS EXAMPLE
DILUTED EPS Calculation
Denominator = 100,000 (basic shares) + 10,000 (in the money options) – 8,000 (buyback) = 102,000 shares
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 units.
- 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 options, 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 EPS. Here we discuss the effect of dilutive securities – convertibles, preferred shares, options/warrants on earnings per shares. You may also have a look at the following articles to learn more about advanced shares –