Diluted Earnings per Share
Diluted Earnings Per Share (EPS) is a financial metric that shows the earnings available to each share of common stock if all convertible securities were exercised. Convertible securities are assets like convertible bonds, stock options, or convertible preferred shares that can be converted into common shares.
Diluted EPS is often viewed as a more accurate measure of a company’s performance, because it takes into account what would happen if all convertible securities were exercised. This metric is especially relevant for companies with complex capital structures.
Here’s the formula for Diluted EPS:
\(\text{Diluted EPS} = \frac{\text{Net Income – Preferred Dividends}}{\text{Weighted Average Number of Shares Outstanding + Potential Shares from Convertible Securities}} \)
It’s important to note that if a company doesn’t have any convertible securities, then its basic EPS and diluted EPS will be the same.
While EPS (either basic or diluted) can give investors a sense of how a company is performing on a per-share basis, it’s also important to look at other financial metrics and the broader context of the company’s operations to get a complete picture of its financial health.
Example of Diluted Earnings per Share
Let’s say we have a company called Tech Inc. Here’s their financial information for the year:
- Net Income for the Year: $1,000,000
- Preferred Dividends Paid: $50,000
- Average Common Shares Outstanding: 400,000
- Stock Options Outstanding: 50,000
First, we calculate the income available to common shareholders by subtracting preferred dividends from net income:
$1,000,000 (Net Income) – $50,000 (Preferred Dividends) = $950,000
Then, we calculate the total number of shares, assuming all convertible securities (in this case, stock options) are exercised:
400,000 (Average Common Shares Outstanding) + 50,000 (Stock Options) = 450,000 shares
Finally, we calculate the Diluted Earnings Per Share:
\(\frac{\$950,000}{\text{450,000 shares}} = \text{\$2.11 per share} \)
So, the Diluted EPS for Tech Inc. is $2.11. This represents the earnings per share if all convertible securities (in this case, the stock options) were exercised. This gives investors a ‘worst case’ scenario regarding earnings dilution, which is particularly useful for companies that have significant amounts of convertible securities.
