Diluted EPS

Introduction to Diluted EPS

Dilution is the reduction in EPS if the securities potentially convertible into common stock. In simple words, we can say that Diluted EPS is a performance indicator used to measure the quality of a company’s earnings per share (EPS) if all convertible securities like options, warrants, convertible preferred shares, etc. were exercised. In many annual reports or research reports, you have seen that they usually report the diluted earnings per share. The reason behind this is investors can determine how would be the earnings per share if convertible instruments were converted into the stock. Thus, diluted EPS gives the worst scenario for earnings per share.

What is meant by EPS and diluted EPS?

Firstly we will understand the meaning of EPS and diluted EPS simultaneously. EPS also called Earnings per share;

• It helps investors to understand the return on their investment in the stock of a publicly-traded firm.
• It tells investors how much they have earned on their stock in the company on a share price basis.
• EPS can be calculated simply by dividing net income earned in a given reporting period less preferred dividend by the total number of shares outstanding during the same period.

The number of shares outstanding can fluctuate; so typically we use a weighted average method.

Calculation / Formula of EPS

The EPS is calculated by dividing net income less preferred dividends divided by the number of outstanding equity shares. This can be expressed in terms of the following formula:

Earnings per share (EPS) = (Net income – Preference Dividends) / Weighted average common share outstanding

If the capital structure changes (i.e. the number of shares changes) during the reporting period, a weighted average number of equity shares is used to for the calculations of EPS else use a number of outstanding shares.

Preference Dividends

• If Preference shares are non-cumulative then deduct only declared dividends
• If Preference shares are cumulative then deduct only declared dividends or if no dividend is declared, then deduct only one year’s dividends.

The weighted average common share outstanding

Simply it means the number of shares outstanding in a company will often change due to a company issuing new shares, buybacks of existing shares, and other financial instruments such as ESOP converted into the shares. This method incorporates any changes in the number of outstanding shares over a particular reporting period. It is an extremely important number; it is useful to calculate key financial measures such as EPS for the time period.

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Let’s look at the following example:

There is a manufacturing company “Future Manufactures” expertise in making FMCG Products. It has 200,000 shares outstanding at the beginning of the year 2013. After the first six months “Future manufacture” issues an additional 200,000 shares, so now the total outstanding share has been increased up to the 400,000. At the yearend “Future manufacture” reports a profit of $401,000 and a distributed preference dividend $1000.

For which amount of shares you should take for calculation of EPS? 200,000 or 400,000? If you use 200,000 shares then EPS would be $2, (EPS=$401,000 – $1000 /200,000) and If 400,000 shares were used then the EPS would be $1, (EPS=$401,000 – $ 1000/400,000)

Is it the Big Difference between the calculations of EPS? This is one of the main reasons that we prefer to use a weighted average method, as it ensures that financial calculations of EPS will be as accurate as possible in case of changes in the company’s shares over a period. It is calculated by taking the number of outstanding shares and multiplying by reporting period those shares covered, then summing the total. Look at the following chart

Now let’s calculate EPS of Future manufactures. We have Formula for calculation of EPS,

Earnings per share = (Net income – Preference Dividends) / Weighted average common share outstanding

Here we have the details of Future manufactures

• Net income = $401,000
• Preference dividend = $1000
• Weighted number of outstanding shares =300,000

So,

EPS = ($ 401,000 – $ 1000) / 300,000

EPS = $400000 / 300000

EPS = $ 1.33 per share

This is the Basic EPS calculation.

Important Note:

Anti-Dilutive Securities

• When securities are converted into the share which results into the increase in EPS called Anti-Dilutive Securities.
• Anti-dilutive securities are not recorded
• Securities that increase earnings per share are ignored

Effect of convertible debt

Effect on Numerator

• If convertible bonds are dilutive, then the bond’s after-tax-interest expense would not be considered as an interest expense for diluted EPS
• Interest expense multiplied by (1-tax rate) must be added back to the numerator

Effect on Denominator

Basic EPS denominator is adjusted for the equivalent number of common shares created by conversion of all convertible debt

A formula of Diluted EPS

Diluted EPS = (Net income –preferred dividends) + (Convertible Debt interest) * (1- Tax rate) / weighted average common shares outstanding + shares from conversion of convertible debt)

• Before calculating diluted EPS, one needs to check if this security is anti-dilutive
• To check whether the convertible debt is anti-dilutive, calculate

(Convertible Debt interest) * (1- Tax rate) / convertible debt shares

If this number is less than basic EPS, convertible debt is dilutive and should be included in the calculation of diluted EPS

Example:

During 2013, KK Enterprise reported net income of $250,000 and had 100,000 shares of common stock during 2013; KK Enterprise issued 1,000 shares of 10%, par $100 preferred stock outstanding. In 2013 KK Enterprise issued, at par, 600, $1,000, 8% bonds, each convertible into 100 shares of common stock. Compute the diluted EPS. Assume tax rate – 40%

Effect of convertible preferred stock

Effect on Numerator

If a convertible preferred stock is dilutive, then convertible preferred dividend must be added back to the previously calculated income from continuing operations less preferred dividends

Effect on Denominator

Basic EPS denominator is adjusted for the equivalent number of common shares created by conversion of all convertible preferred stock

Diluted EPS = (Net Income – Preferred Dividends) + (convertible preferred dividend) / (Weighted average common shares outstanding + shares from conversion of conv. pref shares)

• Before calculating diluted EPS, one needs to check if this security is anti-dilutive
• To check whether the convertible preferred stock is anti-dilutive, calculate

(Convertible preferred dividend) / Convertible preferred shares

If this number is less than basic EPS, a convertible preferred stock is dilutive and should be included in the calculation of diluted EPS

Example

During 2013, KK Enterprise reported net income of $250,000 and had 100,000 shares of common stock. During 2013, KK Enterprise issued 1,000 shares of 10%, par $100 preferred stock outstanding, each convertible into 40 shares. Compute the diluted EPS. Assume tax rate – 40%

Advantages of Using EPS

• It is an excellent method for determining the profitability of the company.
• EPS is easy very easy to grasp and to calculate.
• EPS evaluate solely the performance of the company and do not consider the stock market prices of the company.

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