What diluted earnings per share (diluted EPS) means
– Diluted EPS estimates how much profit would be attributable to each common share if every security that can be converted into common stock were actually converted. Convertible securities include items such as convertible preferred shares, convertible bonds (debentures), stock options, and warrants. Because it counts potential new shares, diluted EPS gives a more conservative per‑share profit figure than basic EPS.
Key definitions
– Earnings per share (EPS): net income available to common shareholders divided by the weighted average number of common shares outstanding during the period.
– Basic EPS: EPS calculated using only shares currently outstanding (after subtracting preferred dividends).
– Diluted shares: the additional common shares that would exist if all dilutive instruments were exercised or converted.
– Diluted EPS: net income (after any necessary adjustments) divided by the weighted average of currently outstanding shares plus dilutive shares.
Why diluted EPS matters
– It shows a “what‑if” or worst‑case view of per‑share earnings if all option holders or convertible holders exercised their rights.
– Investors and analysts use it to judge how current shareholders’ claims could be reduced by future share issuance.
– Public companies are required to report both basic and diluted EPS on their income statements, so users can see the gap between current and potential per‑share earnings.
Formulas (practical)
– Basic EPS = (Net income − Preferred dividends) / Weighted average common shares outstanding
– Diluted EPS = (Net income − Preferred dividends + Adjustments for conversions if required) / (Weighted average common shares outstanding + Dilutive shares)
Note: If convertible debt is included, the company may need to add back the after‑tax interest expense (because that interest would not be paid if the debt were converted) to the numerator. Follow the accounting guidance for EPS presentation when making such adjustments.
Step‑by‑step checklist to calculate diluted EPS
1. Start with net income for the period.
2. Subtract any preferred stock dividends (to get income available to common shareholders).
3. Identify all potentially dilutive instruments (convertible preferred stock, convertible bonds, options, warrants).
4. Compute how many additional common shares would exist if each instrument were exercised or converted (use treasury‑stock method for options/warrants; use conversion ratios for convertibles).
5. If convertible debt is involved, add back interest expense net of tax to the numerator (if conversion eliminates that interest).
6. Add the dilutive shares to the weighted average common shares outstanding to get the diluted share count.
7. Divide the adjusted numerator by the diluted share count.
8. Check for anti‑dilutive effects: if including a security would increase EPS, it is anti‑dilutive and should be excluded from the diluted EPS calculation.
Worked numeric example
Company ABC — reported data for the year:
– Net income: $11,000,000
– Preferred dividends: $1,000,000
– Weighted average common shares outstanding: 20,000,000
– Potential dilutive shares from options/warrants/convertibles: 20,000,000
1. Basic EPS = (11,000,000 − 1,000,000) / 20,000,000 = 10,000,000 / 20,000,000 = $0.50 per share
2. Diluted share count = 20,000,000 + 20,000,000 = 40,000,000
3. Diluted EPS = (11,000,000 − 1,000,000) / 40,000,000 = 10,000,000 / 40,000,000 = $0.25 per share
Interpretation: If all convertible instruments were exercised, each common share’s claim on earnings would fall from $0.50 to $0.25 in this