Diluted EPS, or Diluted Earnings Per Share, is an important metric for determining how much profit a company earns per share of stock. This metric provides investors and analysts with an extensive overview of the company's profitability. Diluted EPS provides deeper insights into an organisation's financial health and performance.
Let us take a closer look at what diluted EPS is, how it is calculated, as well as its significance in investment analysis.
What is diluted EPS?
Diluted earnings per share (EPS) is an important financial indicator that provides insights into a company's profitability by calculating the net income made for each outstanding share of its common stock. It takes into consideration all convertible securities, including options, warrants, and convertible preferred stock. Essentially, diluted EPS accounts for projected future share commitments, offering stakeholders a comprehensive view.
Also read: Calculate divided per share
Formula and calculation of diluted EPS
The diluted EPS formula is straightforward:
Diluted EPS = (Net income - Preferred dividends) / (Weighted average shares outstanding + Dilutive securities)
This method deducts any preferred dividends from the company's net income and divides it by the total number of outstanding shares, including dilutive securities.
Example of diluted EPS
Consider a company, XYZ Ltd., which declared a net income of Rs. 1,50,000 during the fiscal year. During the same period, the company distributed Rs. 30,000 in preferred dividends. XYZ Ltd. has 200,000 common shares outstanding and has granted 50,000 stock options with an exercise price of Rs. 15 per share. The current market price of XYZ Ltd.'s stock is Rs. 25 per share.
Basic EPS = Net income / Total common shares outstanding
= Rs. 150,000 / 200,000
= Rs. 0.75 per share
Diluted EPS = (Net income - Preferred dividends) / (Weighted average shares outstanding + Dilutive securities)
= (Rs. 150,000 - Rs. 30,000) / (200,000 + (50,000 * (Rs. 25 / Rs. 15)))
= Rs. 120,000 / (200,000 + 83,333.33)
= Rs. 120,000 / 283,333.33
≈ Rs. 0.42 per share
This calculation shows that XYZ Ltd.'s diluted EPS is around Rs. 0.42 per share, accounting for potential dilution from outstanding stock options. We see a substantial difference between this figure and the basic EPS of Rs. 0.75 per share, emphasising the impact of dilutive securities on a company's earnings per share.
Also read: What is interim dividend
Diluted EPS vs. EPS
When comparing diluted EPS to EPS, it is critical to know the subtle differences between the two metrics. The company's net income divided by the total number of outstanding shares is called earnings per share. It offers a straightforward way to evaluate a business's profitability without considering convertible securities' possible dilution. On the other hand, diluted EPS takes into account the possibility of dilution from convertible instruments such as options, warrants, and convertible preferred shares.
This adjustment provides a more accurate view of a company's profitability by accounting for potential future share obligations. As a result, diluted EPS is frequently lower than EPS because it includes possible dilution from convertible securities.
Why do investors and analysts calculate diluted EPS
The calculation of diluted EPS is highly significant for investors and analysts alike. It provides a clearer picture of a firm's financial health, growth prospects, and profitability by taking into account the impact of prospective dilution from convertible securities on earnings per share. This allows stakeholders to make smart investment decisions.
Also read: What is dividend yield
Understanding the formula - How to calculate the numerator?
The net income of the business, minus any paid preferred dividends, serves as the numerator in the diluted EPS calculation. Preferred dividends decrease the revenue available to common shareholders, which has an impact on the diluted EPS calculation, and hence, this adjustment is important.
Should you use fully diluted shares?
Companies may utilise either basic or fully diluted shares outstanding to calculate diluted EPS. While basic shares outstanding only include currently outstanding shares, fully diluted shares include all probable shares that could convert into common shares, giving a more accurate picture of earnings per share.
What does a diluted EPS tell shareholders?
Diluted EPS analyses the possible impact of dilutive securities on a company's earnings per share. While a greater diluted EPS may appear to be advantageous, it is vital to look at other aspects, such as the company's growth potential, financial health, and management team, when making investment decisions.
Is a high diluted EPS better than a low diluted EPS?
A high diluted EPS may imply great earnings per share, but it is not the only factor influencing a company's investment potential. Investors should evaluate a variety of criteria before making investment decisions, taking into account both quantitative and qualitative aspects of the company's performance.
What types of companies report diluted EPS?
Publicly traded companies that have outstanding securities that can be converted into common stock often publish diluted EPS. These securities include convertible bonds, stock options, and convertible preferred shares. By reporting diluted EPS, these firms give stakeholders a better picture of the possible impact of convertible securities on earnings per share. While private companies are not required to report diluted EPS, some may opt to do so, particularly if they plan to conduct an initial public offering (IPO) or wish to provide transparency to potential investors.
Conclusion
Diluted EPS is an essential indicator when evaluating a company's performance and profitability. By accounting for potential dilution from convertible securities, it provides investors and analysts with a more accurate picture. Understanding diluted EPS enables stakeholders to make informed investment decisions by taking into consideration a variety of elements that influence a firm's financial health and growth prospects.
