EPS stands for earnings per share, which helps investors determine how much the company is making for every share outstanding. Companies will have additional capital structures besides common stock, some of which contains an option to convert to common stock. For example, a company may issue at the holder's request preferred stock that carries an option to convert each share to two shares of common stock. Depending on the amount of convertible preferred shares outstanding, the conversion of all these shares could drastically reduce earnings per share. Therefore, investors are also interested in the diluted EPS, which measures the earnings per share as if all of the convertible preferred shares were converted to common shares.
1. Calculate the cost of the required dividends paid to the preferred shares. For example, if the company pays $3 per share and has 60,000 outstanding convertible preferred shares, the company pays $180,000 in dividends on convertible preferred shares.
2. Add the dividends paid to the convertible preferred shares to the company's earnings for the year. For example, if the company's earnings equal $1.82 million, add back the $180,0000 to get $2 million.
3. Calculate the number of additional common shares that would result from the conversion of all convertible shares by multiplying the number of convertible preferred shares by the number of common shares for which each convertible preferred share can be exchanged. For example, if each convertible preferred share can be exchanged for two common shares, and the company has 60,000 shares outstanding, multiply 60,000 by 2 to find that an additional 120,000 common shares would result from the conversion.
4. Add the number of convertible preferred shares outstanding to the number of common shares outstanding to find the number of outstanding shares if all shares were converted. For example, if the company has 500,000 common shares outstanding, add 120,000 to find that after the conversion the company would have 620,000 shares outstanding.
5. Divide the adjusted earnings by the number of shares that would be outstanding after the conversion to find the diluted EPS. In this example, divide $2 million by 620,000 to find the diluted EPS is $3.23.
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