What is Diluted EPS
Diluted EPS refers to the earnings per share (EPS) after considering all financial instruments in the capital structure that give an option to the holder to convert them into equity shares, i.e., debt holders may have an option to convert the loan given to a company into a certain number of equity shares or the CEO of a company may be entitled to receive a certain number of equity shares after completing 1 year at the company after paying a certain price.
Let us now understand the two methods by which we can calculate diluted EPS:
A) IF CONVERTED METHOD:
This method is applied when there are financial instruments such as debt and preferred shares, which can be converted into equity shares in the future by their respective holders. Let’s understand how this works with the help of an example:
- Company ABC reported a net income of $900 for the year and has the following capital structure, which did not change during the year. The tax rate is 20%.
- 8% Debt, convertible into 50 shares of common stock – $500
- Common stock – 100 shares
Solution :Diluted EPS
Step 1: Calculate the basic EPS = $900/100 = $9 per share
Step 2: Calculate the conversion factor = $500 * 8% * (1 – 0.2)/50 = $0.64 per share
Step 3: Since the conversion ratio < the basic EPS, the convertible debt is dilutive
Step 4 : Diluted EPS = $900 + $500 * 8% * (1 – 0.2) / (100 + 50) = $6.21 per share
B) TREASURY METHOD:
This method is applied when company has given stock options to a certain set of people. Let’s understand with the help of an example.
On January 1, 2013, ABC Ltd had
- 180,000 common shares outstanding
- 20,000 preferred shares, $100 par value, 3.5%
- In September 2013, the company issued 30,000 additional equity shares
- The net income for 2013 was $1,000,000
- The company has issued options to its CEO to buy 20,000 shares of common stock at $100 per share
- The market price is $110
Solution : Diliuted EPS
Step 1: Since the exercise price $100 < $110, the option is dilutive
Step 2: There will be an addition of 20,000 equity shares
Step 3: The proceeds from 20,000 shares = 20,000 * $100 = $2,000,000, which assumed to be repurchased at the current price of $110 = $2,000,000/110 = 18,182 shares
Step 4: : Diluted Equity Shares = 20,000 – 18,182 = 1,818 shares
Step 5 : (1,000,000 – 70,000)*/ (190,000* + 1,818)
= $ 4.85 per share
*Preference Dividend = 20,000 * 3.5%* 100 = 70,000
*Calculation of weighted shares outstanding
|Time Span||a) Shares Outstanding||b) Portion of Year||
(a * b)
|Jan 1 – Aug 31||180,000||2/3||120,000|
|Sept 1 – Dec 31||210,000||1/3||70,000|
It is extremely important to calculate diluted EPS while making financial models and doing valuations, as accounting involves factoring in all possible downturns as per the principle of conservatism.
A questions for you – Can Diluted EPS be more than Basic EPS 🙂
We look forward to your comments and shares.