DILUTED EARNING PER SHARE

Definition:
The web definition of diluted earning per share is

“Diluted Earnings per Share (diluted EPS) is a company's earnings per share (EPS) calculated
using fully diluted shares outstanding (i.e. including the impact of stock option grants and
convertible bonds).”

According to investopedia the diluted EPS means

“A performance metric used to gauge the quality of a company's earnings per share (EPS) if all
convertible securities were exercised. Convertible securities refer to all outstanding convertible
preferred shares, convertible debentures, stock options (primarily employee based) and
warrants. Unless the company has no additional potential shares outstanding (a relatively rare
circumstance) the diluted EPS will always be lower than the simple EPS”.

Explanation Of Diluted EPS:

Remember that earnings per share are calculated by dividing the company's profit by the
number of shares outstanding. Warrants, stock options, convertible preferred shares, etc. all
serve to increasing the number of shares outstanding. As a shareholder, this is a bad thing. If
the denominator in the equation (shares outstanding) is larger, the earnings per share is
reduced (the same profit figure is used in the numerator). 

This is a conservative metric because it indicates somewhat of a worst-case scenario. On one

hand, everyone holding options, warrants, convertible preferred shares, etc. is unlikely convert
their shares all at once. At the same time, if things go well, there is a good chance that
all options and convertibles will be converted into common stock. A big difference in a
company's EPS and diluted EPS can indicate high potential dilution for the company's shares,
an attribute almost unanimously ostracized by analysts and investors alike.
 Formula of Diluted EPS:
Diluted EPS= Net income – Preferred dividends + convertible P.D+ convertible debt interest (1 - t)

Weighted avg. shares+ shares from conversion of conv. P.D shares+ shares from conv. of

Conv. Debt+ shares issuable from stock options

EXAMPLE 1

Company ABC has: 

- Net income of $2m and 2m weighted average number of shares outstanding for the accounting
period.
- Bonds convertible to common stock worth $50,000: 50 at $1,000, with an interest of 12%.
They are convertible to 1,000 shares of common stock.
- A total of 1,000 convertible preferred stock paying a dividend of 10% and convertible to 2,000
shares of common stock, with a par of $100 per preferred stock.
- A total of 2,000 stock options outstanding, 1,000 of which were issued with an exercise price of
$10 and the other 1,000 of which have an exercise price of $50. Each stock option is convertible
to
  10 common stocks.
- A tax rate of 40%.
- Stock whose average trading price is $20 per share.

Calculate the diluted EPS

SOLUTION

Assume conversion:

If the debt is converted, the company would have to issue an additional 50,000
(50*1,000) common stock. As a result the WASO would increase to 2,050,000.

Since the debt would be converted, no interest would have to be paid. Interest was
$6,000 per annum. The interest expense would flow through to common stockholders
but not before the IRS get a portion of it. So net of taxes the company would have
generated an additional $3,600 [(6,000*(1-40%)] in net income.

Adjusted WASO: 2,050,000

Adjusted net income: $2,003,600

Diluted Eps= 2,003,600 – 6000 + 6000 = $ 0.974

2,050,000+2,000+5,000

         

Example 2

During 20x6 Zzz corp. net income $ 115,600

200,000 shares of common stock outstanding

Zzz corp. also had 1000 shares of 10%, $100 par preferred stock outstanding during
20x6

During 20x5 zzz issued 600, $ 1000par, 7% bonds for $ 600,000(issued at par)

Each of these bonds is convertible to 100 shares of common stock

Tax rate is 40%

Compute the 20x6 basic and diluted eps.

SOLUTION

Step 1: basic Eps

Net income - pref.div = 115,600 – 10,000 = $ 0.53

Wt. avg. shares of common 200,000

Step 2: Diluted Eps

Share issuable for debt conversion= (600) (100) = 60,000 shares

Increase in income= [(600) (1000) (0.07)] (1- 0.40) = $ 25,200

Diluted Eps= 115,600 – 10,000 + 25,200 = $ 0.50

200,000 + 60,000

REFERANCE:
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