Basic EPS vs Diluted EPS
Basic EPS and Diluted EPS are two different figures used to denote earnings per share (EPS). If you are an investor having invested in a company, you are always interested in an indicator known as Earnings per Share or EPS. In the financial statement of any company, there are two figures corresponding to this term which are basic earnings per share and diluted earnings per share. Let us suppose you know that the net worth of a company is $1 billion. You can divide this figure by the total number of outstanding shares to arrive at a figure that should theoretically be the earnings per share, but in reality it is not so simple.
All companies have tools that allow them to increase the number of outstanding shares any time they want. These tools are stock options, warrants, convertible preferred stock and secondary equity offerings. By using any of these tools, a company can increase the number of outstanding shares thus diluting the earnings per share. As the number of outstanding shares goes up, earnings per share automatically comes down which is why it is referred to as diluted earnings per share. Only basic EPS is reported by companies that have no dilutive securities or report net loss.
Every new share that is issued by the management of as company decreases the share of an investor in the assets of the company. Some times, though shareholder’s may not feel the pinch as the difference between EPS and diluted EPS is miniscule, company may be using a huge amount of money from the shareholders to divest it elsewhere. One example would suffice this point. One giant software company reported a difference of just $0.06 in its EPS and diluted EPS in 2009, which did not mean much to shareholders, but considering the fact that the company had an outstanding 6.5 billion shares, this amounted to nearly $300 million that the company took away from the investors and gave it to management and the employees. Thus it is clear that an investor has to pay attention to both EPS and diluted EPS before taking the plunge.
Diluted EPS is, in general always less than basic EPS and holds significance while making investment decisions. Share prices of a company are decided largely by the value of its EPS and it is also an integral part of any price to valuation ratio. Though two companies may be having same EPS, it is advisable to look at the equity that is used by both companies. It is the company that has used less equity to generate the EPS is obviously the better performing company of the two. In conclusion, though EPS is a strong indicator of a company’s financial health, it is prudent to look it in conjunction with other parameters to arrive at any investment decision.