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Investors use many tools and metrics to determine a stock’s profitability and gauge the risks of their investments. But two measures, earnings per share (EPS), and diluted EPS are two of the most commonly utilized measures of a company’s financial state. Although the two figures monitor slightly different aspects of a company’s profitability, the combination of the two paints a picture of actual and worst-case-scenario earnings, and potential dividends.
It’s important to understand EPS calculations and what they represent in order to grasp diluted EPS figures. EPS is ratio that represents the amount of total profits, less dividend payments to preferred stock holders, to the average number of held shares during the reporting period. This figure represents the highest dividend per share if the company doesn’t retain any earnings, and serves as a basic measure of a company’s overall profitability.
It’s rare that a publicly traded company would have no outstanding obligations other than preferred and common stock, even if those shares aren’t actively traded at the moment. Many companies provide stock options to their employees, and many options remain unvested, and preferred stock holders may hold the option to convert their holdings to common stock. Diluted EPS measures a company's earnings if all these outstanding obligations convert – diluting the value of shares – and the company splits earnings among all potential shares.
Calculating Diluted EPS
To determine diluted EPS, convert the number of outstanding shares, and warrants and then recalculate EPS using the potential number of dilutable shares. The basic formula for determining diluted EPS is: Diluted EPS = (total income – preferred dividend payments)/(weighted average of shares outstanding + diluted shares). For example, you may want to calculate diluted EPS for a company that posts $500,000 in profits, owes preferred stockholders $100,000 in dividends, and has a weighted average shares outstanding of 100,000, with another 50,000 potentially dilutable shares on the books. For this, the calculation would be diluted EPS = ($500,000 – $100,000)/(100,000 + 50,000). Diluted EPS = $2.67
Calculating Number of Diluted Shares
The number of potentially diluted shares isn’t converted to real-world shares on a one-to-one basis. Before performing the diluted EPS calculation, a company must convert stock options to diluted shares based on the difference between the option price and market price. To do this, a company multiplies the number of optionable shares by the option price to determine total option proceeds. Option proceeds are then divided by the stock’s market price to determine the number of shares those proceeds could buy on the open market. The number of translated shares are then subtracted from the total number of optionable shares to determine the number of diluted shares. Diluted shares = number of optionable shares – [(number of optionable shares x excise price)/market value]. For example, assume a company provides 1,000 shares to workers at an option price of $5 each, and the market value of its shares is $7.50. Its number of diluted shares can be calculated as diluted shares = 1,000 – [(1,000 x $5)/$7.50] Diluted shares = 333.