When individuals purchase stock, they want to know the company plans to use their money to grow the business and increase the value of their investments. These individuals review the financial statements of the company and calculate various ratios based on the numbers appearing in the financial statements. Profitability ratios demonstrate how much money the company earned during the period. Earnings per share, or EPS, is one profitability ratio used by investors. Several variations of EPS exist, and each treats convertible preferred stock and bonds differently.
The purpose of earnings per share is to communicate the portion of net income attributable to each share of common stock. As this ratio increases, the value of each share of common stock increases. The earnings per share ratio increases when the company reports a higher net income or when the number of outstanding shares of common stock decreases.
Basic earnings per share is determined by subtracting preferred stock dividends from net income and dividing the result by the weighted average number of shares of common stock outstanding. The investor uses the weighted average number of shares because the number of stockholders who invest in the company during a reporting period varies. This allows the investor to consider the investment of all the stockholders. The investor only considers the shares outstanding because they represent the stock issued to investors.
Convertible securities include both convertible preferred stock and convertible bonds. The investor holds the option of maintaining the security in its present form or converting it to common stock. When the investor converts the security, she loses her right to the benefits of that security, such as preferred stock dividends or interest payments. In exchange, she receives a predetermined number of shares of common stock and shares in common stock dividends or sells the shares at the current market price.
Diluted earnings per share revises the weighted average number of shares of common stock outstanding to consider the impact if all the convertible securities were converted. The company calculates the number of common shares for which all convertible preferred stock could be exchanged. The company also calculates the number of shares for which all convertible bonds could be exchanged. These increase the weighted average number of shares of common stock outstanding and decrease the company’s earnings per share.