Basic Earnings Per Share vs. Diluted Earnings

Basic Earnings Per Share vs. Diluted Earnings explained by professional Forex trading experts the “ForexSQ” FX trading team. 

Basic Earnings Per Share vs. Diluted Earnings

Next up in our lesson on analyzing the income statement is a discussion on the difference between basic earnings per share, or Basic EPS, and diluted earnings per share, or Diluted EPS.  This is a particularly important area for you stock investors because, if you aren’t careful, you can end up using the wrong EPS figure and thus end up with a misleading price-to-earnings ratio, PEG ratio, and dividend-adjusted PEG ratio.

Understanding the Difference Between Basic EPS and Diluted EPS

When you dive into the profit and loss statement of a company, you have to do it on two levels.

  • The first is looking at the entire business.  Namely, how profitable is the company as a whole?
  • ​​The second is examining the profits per share.  Remember that publicly traded companies are cut up into individual pieces with each of those pieces representing part of the overall ownership pie.  How much of the after-tax income is each individual piece of the company entitled to receive?

For the individual investor, the latter figure is what really counts.  If a company generates more and more profit each year, but very little of that additional profit makes its way to the shareholders on a per share basis due to dilution arising from new share issuances for mergers and acquisitions, stock options given to executives, or dilutive securities such as warrants or convertible preferred stock, the prosperity of the business doesn’t mean much as it could still be a terrible investment.

 This is a fairly common problem and one you’ll likely discover more often than not.  Truly shareholder-friendly management teams focus on the per share results, prioritizing it over the size of the company.  They understand that each time a new share is issued, the existing owners are, in effect, selling some of their current business assets and giving it up to whoever is receiving that share.

Fortunately, the accountants who develop the GAAP rules for financial statementsfound in the annual report and 10-K filing came up with a solution.  It’s not perfect, and it won’t catch everything, but it’s a great place to start.  They decided to require two different earnings per share figures to be displayed by companies in their disclosures.

  • The first is known as Basic EPS.  Basic earnings per share is a straight-forward, simple calculation that attempts to take the net income applicable to common shares for a period and divide it by the average number of shares outstanding for that same period.  For example, if a business had $100,000,000 in net income applicable to common shares for its most recent fiscal year, and it started that year with 20,0000,00 shares outstanding and ended that year with15,000,000 shares outstanding, the Basic EPS calculation would be $100,000,000 ÷ ([20,000,000 + 15,000,000] ÷ 2), or $5.71.
  • The second is known as Diluted EPS.  Diluted earnings per share adjusts the Basic earnings per share figure by including all potential dilution that, if triggered at present prices and conditions, would result in the reported earnings per share being lower than they otherwise would have been.  For example, using our earlier illustration, if there were 5,000,000 shares of stock that could be issued at any time due to a convertible security held by an early investor being eligible for conversion at a price lower than the current market price, the formula would need to account for that.  Diluted EPS would be $100,000,000 ÷ ([[20,000,000 + 15,000,000]+5,000,000] ÷ 2), or $4.44.

Some Thoughts On Using Diluted EPS When Analyzing a Business

One thing to keep in mind about Diluted EPS, which we will discuss later in this lesson, is the fact that anti-dilutive conversions aren’t included in the calculation.  The reason for this is that doing so would increase earnings per share, which isn’t likely to happen in the real world (what sane person would exercise an underwater option or convertible security at a price that causes them to pay more than they could get if they went to the open market and bought shares?).  This means, to provide one illustration, underwater stock options aren’t included in the Diluted EPS calculation but stock options that are eligible for conversion and have a strike price below the current market price are.

From a practical standpoint, when you understand this, the implications become clear: If a company has a lot of potential dilution on its books, and the stock price then declines either due to a company-specific situation, a recession, or a broad stock market collapse, all of that dilution could disappear from the Diluted EPS calculation.

 If you don’t account for the fact that higher future stock levels will suddenly re-introduce all of that dilution, your projected earnings could be far off the mark, causing you to have overpaid for the business.  To some extent, at least so far as stock options go, if the stock price remains depressed for a long period of time, some stock options will expire but that’s usually cold comfort as management is likely to issue itself new stock options at the lower price.

A general rule of thumb to remember is that Diluted EPS will always be lower than Basic EPS if the company generated a profit because that profit has to be divided among more shares.  Likewise, if a company suffers a loss, Diluted EPS will always show a lower loss than Basic EPS because the loss is spread out over more shares.

When I first wrote this lesson back in 2001 or 2002, I used figures from a technology company, Intel, in the aftermath of the dot-com boom that demonstrated all of this.  They are such a good illustration of everything we’ve been discussing that I’m going to keep them in place as it doesn’t provide any particularly useful insight to chance them to more recent numbers.  Looking at the chart I’ve affixed to the bottom of this page, notice that in 2000, the difference between Intel’s Basic EPS and Diluted EPS around to around $0.06.  If you consider the company had over 6.5 billion shares outstanding, you realize that dilution was taking more than $390 million in value from the investors and giving it to management and employees.  That was a huge amount of money.  Later, in 2001, as the markets continued to collapse, a lot of the stock options went underwater and thus the dilution effect evaporated temporarily in the calculation of Diluted EPS.

                                                          Table INTEL-1

Excerpt – 2001 Annual Report
Earnings per share from continuing operations20012000
Basic EPS$0.19$1.57
Diluted EPS$0.19$1.51

Basic Earnings Per Share vs. Diluted Earnings Conclusion

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