What it means
Diluted earnings per share exists to answer one question: if every convertible instrument, option and warrant turned into ordinary shares, what would each share have earned? The point of the measure is caution, so it should never make a company look better than its basic EPS.
Some instruments, when converted, add more to the numerator than they cost in extra shares. A convertible bond, for instance, removes interest expense when it converts, and if that interest saving is large relative to the new shares created, EPS goes up rather than down.
When that happens the instrument is antidilutive and is simply excluded from the calculation. This is not a judgement call, it is a required test performed instrument by instrument, and each one is assessed on its own before the results are combined.
The order of the test matters. Instruments are ranked from most dilutive to least, then added one at a time, and the moment adding one would raise EPS, that instrument and every less dilutive one after it are dropped.
The nuance that catches people out is that antidilutive status is not permanent. An option that is out of the money this year becomes dilutive if the share price rises, and a convertible that is antidilutive in a weak profit year becomes dilutive when earnings recover, so the population changes every reporting period.
In practice
Real-world examples.
Example
A biotech company reports a net loss for the year. All of its outstanding share options are automatically antidilutive, because adding shares to a loss makes the loss per share smaller, so diluted loss per share equals basic loss per share.
Example
A property group has share options with an exercise price of $42 while the average share price for the year was $35. The options are out of the money, so they create no incremental shares and are excluded as antidilutive.
Example
A manufacturer's low-coupon convertible bond is dilutive in a strong year but becomes antidilutive when profits halve. The finance team must rerun the ranking test each period rather than carrying forward last year's conclusion.
Formula
Calculation
The test compares basic EPS with the incremental effect of each instrument:
Diluted EPS = (Net income + After-tax interest saved) / (Basic shares + New shares on conversion)
If the result is higher than basic EPS, the instrument is antidilutive and excluded.
Suppose a company reports net income of $8,000,000 and has 4,000,000 ordinary shares outstanding.
Basic EPS = $8,000,000 / 4,000,000 = $2.00.
It also has $10,000,000 of 6% convertible bonds that would convert into 200,000 shares. Annual interest is $10,000,000 x 0.06 = $600,000. At a 25% tax rate, the after-tax interest saved on conversion is $600,000 x 0.75 = $450,000.
Adjusted numerator = $8,000,000 + $450,000 = $8,450,000.
Adjusted denominator = 4,000,000 + 200,000 = 4,200,000.
Test EPS = $8,450,000 / 4,200,000 = $2.01.
Because $2.01 is higher than the basic $2.00, the bonds are antidilutive and must be excluded. Diluted EPS is therefore reported as $2.00, the same as basic EPS.Case study
Seen in the real world.
Larkfield Systems, a fictional listed technology firm presented here as an illustrative example, restated its diluted EPS after an internal review. The company had four classes of potential shares: two convertible bond issues, an employee option pool and a tranche of warrants.
The reporting team had added all four into the diluted calculation as a single adjustment, on the reasonable-sounding logic that dilution should capture everything outstanding. The review found that the older convertible, which carried a high coupon and converted into relatively few shares, was antidilutive and had been quietly propping up the reported figure.
Excluding it moved diluted EPS from $1.34 to $1.29, a difference of 5 cents that mattered because analyst estimates clustered at $1.31. In this illustrative account the fictional company rebuilt its EPS working paper to rank instruments individually, which is what the rules required all along.
Watch out
Common mistakes.
- Adding every convertible instrument and option into diluted EPS as one lump, instead of testing each one separately and ranking them.
- Assuming diluted EPS can legitimately come out higher than basic EPS. If it does, an antidilutive item has been wrongly included.
- Carrying forward last year's conclusion about which instruments are dilutive, when share price and profit changes reshuffle the ranking every period.
Questions
People also ask.
Why are all potential shares antidilutive when a company makes a loss?
Because spreading a fixed loss over more shares reduces the loss per share, which improves the reported figure and so must be excluded.
Does an antidilutive instrument get disclosed anywhere?
Yes. Companies are normally required to disclose the number of potential shares excluded as antidilutive, so readers know what is sitting outside the calculation.
Can the same instrument be dilutive and antidilutive in the same year?
Not within one calculation, but it can flip between interim periods and the full year, which is why year-to-date figures are not simply the sum of the quarters.
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