Understanding the Difference Between Basic EPS vs. Diluted EPS

This blog post discusses the importance of financial metrics such as basic earnings per share (EPS) and diluted EPS in evaluating a company’s financial health and profitability. The article outlines the basic definitions of these two metrics and explains how they differ from each other. Read on to get a grip on these key concepts and the uses of basic EPS and diluted EPS.

Earnings per share (EPS) vs. Diluted EPS: An overview

Understanding the difference between Basic Earnings Per Share (EPS) and Diluted EPS is crucial in analyzing a company’s financial performance. Let’s explore the two types of EPS and how they impact the earnings per share calculations.

Earnings per share (EPS)

EPS is a financial metric used to measure a company’s profitability. It indicates how much profit a company has generated per outstanding share of common stock. EPS is a critical metric used by investors to evaluate a company’s financial health and to compare its profitability with other companies. However, changes in the number of outstanding shares, currency rates, and other non-recurring variables can impact EPS. Further, it is reported on the income statement and is typically calculated for a specific period, such as a quarter or a year.

The formula for calculating EPS is:

EPS = (Net income – preferred dividends) / Average outstanding shares

In the above formula, net income is the company’s total income after all expenses have been deducted, and preferred dividends are any dividends paid to holders of preferred stock. Average outstanding shares refer to the average number of shares of common stock outstanding during the company’s earnings period.

Diluted EPS

Diluted EPS is a financial metric that provides a more comprehensive measure of earnings per share (EPS) by considering the potential impact of dilutive securities, such as stock options, convertible bonds, and warrants. Dilutive securities can potentially increase the number of outstanding shares, thereby reducing regular EPS. You have to assume that all dilutive securities have been exercised or converted into common stock. This approach provides a more accurate picture of a company’s earnings potential. Investors often prefer this over regular EPS.

The formula for calculating the metric is:

Diluted EPS = (Net income – preferred dividends) / (Weighted average shares outstanding + potential dilutive shares)

In the above formula, potential dilutive shares refer to additional shares that would be outstanding if all dilutive securities were exercised or converted into common stock. The weighted average shares outstanding include all common shares that are currently outstanding, as well as any additional shares that were issued during the evaluated period, such as through stock offerings or acquisitions. By factoring in the impact of dilutive securities, diluted EPS provides a more accurate estimate of a company’s EPS.

Example of earnings per share (EPS) vs. diluted EPS

Let’s assume that a company has a net income of ₹10 crore, with 10 million shares of common stock outstanding. Besides, 1 million outstanding stock options have an exercise price of ₹5 per share. The current market price of the company’s stock is ₹15 per share.

To calculate EPS, we would divide the net income by the weighted average number of shares outstanding:
EPS = ₹10 crore / 10 million shares = ₹ 1.00 per share

To calculate diluted earnings per share, we need to factor in the potential impact of the stock options. Since the exercise price of the options is lower than the stock’s current market price, it is likely that the options will be exercised, and more shares will be added to the total.

To calculate the potential impact, we use the “treasury stock method,” which assumes that the proceeds from the exercise of options are used to repurchase common stock at the average market price. Applying this, we obtain:
Potential dilutive shares = 1 million options * (₹15 – ₹5) / ₹15 = 0.67 million shares

Adding the potentially dilutive shares to the weighted average number of shares outstanding gives us the denominator for diluted earnings per share:

Weighted average shares outstanding + potential dilutive shares = 10 million + 0.67 million = 10.67 million shares
Using this denominator in the EPS formula, we obtain:
Diluted EPS = Rs. 10 crore / 10.67 million shares = ₹0.94 per share

Is EPS or diluted EPS better?

The choice of which metric to use depends on the specific situation and the investor’s goals. If the company has no dilutive securities, then EPS is the appropriate metric.

EPS is useful for comparing the profitability of companies with different numbers of outstanding shares and tracking a company’s profitability over time. On the other hand, the diluted metric is important for investors who want to assess the potential impact of dilutive securities on a company’s EPS.

However, suppose the company has a complex capital structure with convertible securities. In that case, the diluted version is more appropriate to better understand the potential impact of those securities on the company’s EPS. In general, it’s important to look at both the metrics, along with other financial metrics such as revenue growth, profit margins, and cash flow, to obtain a more complete picture of a company’s financial performance.

Why is diluted EPS important?

Diluted EPS helps investors understand the true earning potential of a company and its ability to generate profits. Since it considers the potential dilution from other securities, it represents a company’s EPS more accurately. It is a common metric that analysts use to assess a company’s performance and benchmark it against its competitors.

Moreover, the metric can impact the market value of a company’s stock as investors typically pay close attention to a company’s earnings and EPS when making investment decisions. A higher EPS reading can indicate a more valuable company and increase the stock price.

What does a higher EPS indicate?

A higher EPS typically indicates that a company is generating more profit per share of its outstanding stock. This can be a positive sign to investors, potentially leading to a higher stock price as investors are willing to pay more for a profitable company.

Conclusion

Investors use basic EPS and diluted earnings per share to evaluate a company’s financial performance. While diluted earnings per share offer a more conservative estimate that considers the potential dilution impacts of convertible securities, EPS provides a fundamental measure of a company’s profitability.

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