Difference Between Basic Earnings Per Share and Diluted Earnings Per Share

Basic Earnings Per Share vs Diluted Earnings Per Share | Basic EPS vs Diluted EPS
 

Earnings per share is a calculation conducted in order to find the earnings that a company obtains as per the number of outstanding shares held. Earnings per share and diluted earnings per share are easily confused by many due to the difficulty that many face in understanding the meaning of ‘diluted’ earnings. Diluted earnings per share has a different meaning to basic earnings per share, which can be quite subtle. The following article aims to provide the reader a clear explanation of what is meant by basic earnings per share and diluted earnings per share, and clearly explain the difference between the two.

What is basic earnings per share?

The basic earnings per share is calculated as follows. Basic EPS = (Net Income – Preference dividend) / number of shares outstanding. The basic earnings per share measures the number of dollars of net income that is available for one of the company’s outstanding shares. The basic earnings per share is a measure of profitability and is considered to be an important determinant of a share’s true price. Basic earnings per share is also used in other important financial ratio calculations such the price-earnings ratio. It must be noted that two companies could generate similar EPS figures, but one firm may do so by using of less equity, which would make the firm more efficient than the firm that issues more shares and arrives at the same EPS.

What is diluted earnings per share?

The diluted earnings per share is calculated by taking into consideration the stock options, convertibles (bonds & stock), warrants and other securities that could create dilution. The diluted EPS calculates the value of the EPS, if the potential dilutive securities are exercised. For a shareholder of a firm, dilution in the EPS is not favourable, because this means that the net income will remain the same while the outstanding shares could become much larger. In this case, the EPS figure would be reduced to a great extent. For example, a firm XYZ may have shares outstanding of 1000 today, but that figure may easily be increased to 3000 resulting from a conversion of shares. This would reduce their EPS figure by 3 times, which is quite a loss given that the net income will not change.

What is the difference between basic earnings per share and diluted earnings per share?

The main similarity between basic EPS and diluted EPS is the basic calculation that forms the basis for both. However, the two are quite different from each other because basic EPS will only consider the shares currently outstanding and does not consider the potential dilution that could occur from convertibles, options, warrants, etc. The basic EPS will always be higher than a diluted EPS, since the diluted EPS will result in more outstanding shares, in calculations, but will use the same net income used in the basic EPS calculation. It is important to calculate the diluted EPS, as it takes into consideration the EPS that would result in the worse possible scenario, if all possible dilution took place. Furthermore, an investor may not be willing to purchase shares that have a significant difference between their basic EPS and diluted EPS due the potential negative effect that a dilution may have on the price of the share.