Basic Earnings per Share vs. Diluted Earnings

When you're analyzing an income statement, it's vital to know the difference between earnings per share (EPS) and diluted earnings per share (diluted EPS). This is a key area for stock investors, because you might end up using the wrong EPS figure. It also might cause you to end up with a false price-to-earnings ratio, PEG ratio, and dividend-adjusted PEG ratio.

What Are Basic and Diluted Earnings per Share?

When you dive into the income statement (also known as the company's "profit and loss statement"), you have to consider the following:

1. The entire business: How profitable is the company as a whole?
2. The profits per share: Publicly traded companies are cut up into individual pieces or "shares." Each of those shares represents part of the overall ownership pie. How much of the after-tax income is each piece of the company entitled to receive? 

Earnings per share is a company's net income, minus cumulative preferred dividends, divided by the number of common outstanding shares. 

Diluted earnings per share represent the company's net income minus preferred dividends, divided by the total of the weighted average number of shares and other dilutive securities.

To an investor looking for dividends, the second figure is what counts. A company might create more profit each year but give little of that profit to the shareholders per share. That is not good for a shareholder who invests for dividends, but it might be good for someone who looks for rising share values.

Profits get lost (diluted) on their way to shareholders for many reasons. For instance, a merger may result in new shares being issued. Employees may have stock options with vesting periods that are ending. There also may be securities such as warrants or convertible preferred stock issued that dilute a stock.

You'll run into these details more often than you might expect. Management teams that respect shareholders will focus on the per-share results, prioritizing them over the size of the company. That type of management understands what happens each time a new share is issued: The current shareholders are, in effect, giving up some of their stake in the firm to the new share.

Fortunately, the agency that developed the reporting standards (generally accepted accounting principles, or GAAP) came up with a solution. It's not perfect, and it won't catch everything, but it's a great place to start. The agency decided to require companies to present two EPS figures in their disclosures: basic earnings per share and diluted earnings per share.

Calculating Basic Earnings per Share

Basic EPS is a calculation that attempts to take the net income applicable to common shares for a period and divide it by the average number of shares outstanding for that same period.

For example, suppose a business had $100 million in net income applicable to common shares for its most recent fiscal year. It started that year with 20 million shares outstanding and ended that year with 15 million shares outstanding. The basic EPS calculation would be:

$100 million ÷ ([20 million + 15 million] ÷ 2) = $100 ÷ 17.5 million = $5.71

The basic EPS for this firm is $5.71.

Calculating Diluted Earnings Per Share

Diluted earnings per share adjust the basic EPS figure by including all potential dilution that would result in the reported earnings per share being lower than they might have been if triggered at current prices and conditions.

Let's stick with our example from the basic EPS but add a new detail: An early investor holds a convertible security that could result in five million more shares being issued when the investor wants to convert it. That's in addition to the average outstanding shares of 17.5 million from the basic EPS example. The diluted EPS equation would then be:

$100 million ÷ (([20 million + 15 million] ÷ 2) + 5 million) = $100 million ÷ (17.5 million + 5 million)

That gives a diluted EPS of $4.44.

Some Quirks to Diluted Earnings Per Share

One thing to keep in mind about diluted EPS is that anti-dilutive conversions are not included in the calculation. To include them would increase earnings per share, which isn't likely to happen in the real world.

For example, an employee with a vested option to buy a stock at $1 per share won't exercise that option when the stock is trading at $0.75 per share. Underwater stock options aren't included in the diluted EPS calculation. The only stock options included are the ones that are eligible for conversion and have a strike price below the current market price.

If a company has a lot of potential dilution on its books and the stock price quickly declines, it could all could disappear from the diluted EPS calculation. If you don't account for the fact that higher stock levels in the future will bring back all of that dilution, your projected earnings could be far off the mark. If the stock price remains down for a long time, some stock options will expire, but that's usually cold comfort. Firms are likely to issue new stock options at a lower price.

One general rule of thumb is that diluted EPS will always be lower than basic EPS if the company creates a profit because that profit has to be spread among more shares. Likewise, if a company suffers a loss, diluted EPS will always show a lower loss than basic EPS, because the loss is spread out over more shares.

Looking at Intel as an Example

The figures below are from Intel after the dot-com boom. The chart shows that in 2000, the difference between Intel's basic EPS and diluted EPS amounted to around $0.06.

If you consider that the company had over 6.5 billion shares outstanding, you realize that dilution essentially took away more than $390 million in value from the investors. In 2001, as the markets continued to collapse, many stock options went underwater, which caused the dilution effect to go away for a short time.