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What Is Diluted EPS?
Let me explain diluted EPS directly to you. Earnings per share, or EPS, is a key way to gauge a company's profitability, and diluted EPS takes a more conservative approach by showing what EPS would be if all convertible securities were exercised right away. These securities include things like preferred shares, debentures, stock options, and warrants, and exercising them would lower the EPS figure.
Key Takeaways
You should know that diluted EPS measures earnings per share assuming all convertible securities are turned into common stock. Dilutive securities are those that can convert to common stock, and this dilution process reduces the value of existing shareholders' equity while cutting the firm's overall EPS.
EPS vs. Diluted EPS
Basic EPS looks at the company's net earnings divided by its current outstanding shares. But when I talk about diluted EPS, I'm including potential future shares from obligations like convertible preferred stock, stock options, and convertible bonds. If these get exercised, they boost the number of shares and dilute the EPS. For instance, convertible preferred stock can switch to common shares anytime, stock options let buyers get common stock at a fixed price after vesting, and convertible bonds convert based on holding time.
Important Note on Dilution
As a shareholder, you typically push back against dilution because it devalues your current equity and drops the company's EPS.
Formula and Calculation
The basic EPS formula is straightforward: take net income minus preferred dividends, then divide by the weighted-average outstanding common shares. For diluted EPS, you add in the dilutive shares—those from potential obligations being exercised—to the denominator along with the existing shares.
Example of Diluted EPS
Consider Company ABC with $11 million in net income, $1 million in preferred dividends, 20 million outstanding shares, 5 million from employee stock options, and 15 million from convertible bonds. Basic EPS comes out to $0.50 per share: ($11M - $1M) / 20M. But diluted EPS drops to $0.25: same numerator over (20M + 20M dilutive shares). This gives you a clearer, more accurate view of the company's finances, especially since many firms have these potential share issuances.
What EPS Tells Investors
EPS is a solid metric for checking a company's financial health, and public companies have to report both basic and diluted versions on their income statements. Diluted EPS shows the worst-case scenario where all dilutive items like options and warrants convert at once, which can worry analysts and investors about share dilution. For example, if a company has $9 billion in shares and a $0.10 gap between basic and diluted EPS, that points to $900 million in potential new shares.
How Does Diluted EPS Affect Shareholders?
When dilutive securities convert, they increase the weighted average of outstanding shares, which lowers EPS and devalues your existing stake as a shareholder.
Is a High Diluted EPS Better Than a Low One?
Yes, a higher diluted EPS is preferable to a lower one, but ideally, you want a high diluted EPS with minimal difference from the basic EPS. This setup suggests less dilution risk and can lead to higher market valuations, with investors paying more per share.
What Types of Companies Report Diluted EPS?
Publicly traded companies are required to report both EPS and diluted EPS. Private companies don't have to disclose these metrics.
The Bottom Line
In summary, diluted EPS assesses earnings per share assuming all convertible securities are exercised, which dilutes shareholder equity and reduces EPS. Public companies must include both EPS figures in their reports, so keep this in mind when evaluating investments.
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