How to Calculate Diluted Earnings Per Share (8 Video Links)

Analysts, CFOs, and other professionals need to know how to calculate diluted earnings per share. To understand diluted earnings per share, start with the basic earnings per share formula. From there, this article reviews the dilutive transactions that are used in the diluted earnings per share formula and weighted average shares outstanding.

 

Earnings Per Share Formula

 

The basic calculation for earnings per share (EPS) is:

 

(Earnings per common share) / (Weighted average common stock shares outstanding)

 

The dilutive EPS formula is different, because dilutive securities change the weighted average common stock shares outstanding.

 

Here are three components of the calculation:

 

• Net income: Earnings refer to net income generated in the income statement and posted as an increase to equity in the balance sheet.

 

• Common shares: Basic EPS applies to company earnings that are available for common stock shareholders. Shareholders can benefit by receiving a portion of earnings as a cash dividend, and higher earnings may also result in a higher stock price per share. EPS focuses on common shareholders only.

 

• Weighted average common stock shares outstanding: The average is computed as [(beginning balance) + (ending balance)] / 2, and the average is typically computed on annual basis.

 

EPS is a frequently used metric to determine the value of a company’s stock.

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Adjusting Earnings for Preferred Stock

Some earnings may not be available to common shareholders. If your firm has preferred stock outstanding, you may have to pay dividends to preferred shareholders before earnings are available to common stock owners.

Say, for example, that total earnings are $1.2 million, and that $200,000 must be allocated to preferred stock dividends. Also assume that the weighted average common shares outstanding total 100,000 shares.

EPS for common stock is ($1 million earnings) / (100,000 shares), or $10 per share.

Several types of securities can be converted into common stock, which impacts the diluted earnings per share calculator.

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Diluted Earnings Per Share Formula

Fully diluted earnings per share assumes that any security that can be converted into common stock is converted, and dilution increases the number of shares outstanding. A diluted earnings per share example problem, assumes that weighted average shares outstanding account includes securities that are dilutive.

As the term implies, “dilutive” means that the impact is spread out, just like putting chocolate powder into a glass of milk. In this case, dilution means more common stock shares outstanding. Here are some securities that are dilutive, and impact the diluted earnings per share example:

• Stock options
• Rights and warrants
• Convertible bonds
• Convertible preferred stock

Convertible bonds

 

Convertible bonds have a provision in the bond indenture (written agreement) that allows a bondholder to convert the bond into a specific number of common stock shares.

 

Assume, for example, that IBM issues a $1,000 corporate bond that is convertible into 20 shares of IBM common stock, and that the market value of the bond is $1,050. If the stock price of IBM common stock is $60 per share, the bondholder can convert the bonds and receive 20 shares of common stock worth (20 share X $60 per share), or $1,200.

 

Converting into common stock changes the investment from a bond (debt) instrument into equity, and the $1,200 market value of the stock is more than the bond’s $1,050 market value. So, converting into stock results in more market value for the investor.

 

Convertible preferred stock

 

Preferred stock differs from common stock. If a company generates earnings and decides to pay a dividend, preferred shareholders receive their dividends before common shareholders.

 

As mentioned above, a diluted earnings per share example only include earnings available to common shareholders. As a result, earnings paid as dividends to preferred stockholders are excluded from the diluted EPS calculation.

 

Some preferred stock is issued with the option of converting to common stock, and a conversion would increase common stock shares outstanding.

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Stock options

 

Many companies offer stock options as a form of additional compensation to employees.

 

As an example, Sally is the CFO of a company, and she is granted the right to buy 500 shares of company stock at a price of $50 per share. If the market price of the stock moves to $65 a share, Sally can profit by exercising her right and buying the stock at $50. She can sell at $65, or hold the stock and try to recognize a larger profit later.

When stock options are exercised, companies are required to file Form 3922 with the IRS. This form reports details such as the transfer date, exercise price, and fair market value of the stock. Proper reporting ensures compliance and helps employees and the IRS track the tax implications of the transaction.

Stock options are dilutive for EPS.

Rights and warrants

 

Rights and warrants also give an investor the means to purchase common stock, and a warrant may be attached as a “sweetener” to another investment, such as a corporate bond.

 

To compute diluted EPS, add up the total number of common stock shares that can be obtained by conversion, and add that total to the existing common shares outstanding (held by the public).

Now that you know about EPS, let’s consider the weighted average shares of stock outstanding.

Calculating Weighted Average Shares Outstanding

The weighted average shares outstanding calculation is the number of common stock shares outstanding, adjusted for stock splits, stock dividends and the transactions explained above. An increase in weighted average shares outstanding reduces earnings per share.

Good luck!

Ken

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies