What it means
Companies routinely issue instruments that turn into shares later. Employee share options, warrants attached to a financing round, convertible loan notes and convertible preferred shares all sit outside the ordinary share count today but can join it tomorrow, and each one represents a claim on future profits.
This matters because earnings per share is one of the most quoted measures in equity markets. A company with a large option pool can report attractive basic earnings per share while the pool quietly waits to expand the share count, so the accounting rules require a second, more conservative figure.
The mechanism is the diluted earnings per share calculation. Basic earnings per share uses the weighted average shares actually in issue, while diluted earnings per share adds the extra shares that would exist if every dilutive equivalent converted, and adjusts profit for anything that would no longer be paid, such as interest on a convertible bond.
For options and warrants, the treasury stock method applies. It assumes the holders exercise, the company receives the exercise proceeds, and it uses that cash to buy back shares at the average market price, so only the net additional shares count as dilution.
An important nuance is that anti-dilutive instruments are excluded. If including a security would raise earnings per share rather than lower it, for example an option priced above the market, it is left out, which is why the diluted figure can never exceed the basic figure.
In practice
Real-world examples.
Example
A venture-backed company preparing to list discovers that its option pool represents 14% of fully diluted shares. Its bankers insist that the prospectus present diluted earnings per share prominently, because sophisticated investors will price the business on the diluted count regardless.
Example
A mid-sized manufacturer issues a convertible bond to fund an acquisition. Its next annual report shows basic and diluted earnings per share diverging noticeably for the first time, prompting questions from analysts about the conversion price and timing.
Example
A retailer's share price falls below the exercise price of most of its outstanding options. Those options become anti-dilutive and drop out of the diluted calculation, so basic and diluted earnings per share converge even though nothing about the option grants has changed.
Formula
Calculation
Basic EPS = net income available to ordinary shareholders / weighted average ordinary shares. Under the treasury stock method, incremental shares = options outstanding - (options outstanding x exercise price / average market price).
A listed software business reports net income of $4,000,000 with 10,000,000 weighted average shares in issue. Basic EPS = $4,000,000 / 10,000,000 = $0.40 per share.
It also has 1,000,000 employee options with an exercise price of $10, while the average market price over the year was $25. Assumed exercise proceeds = 1,000,000 x $10 = $10,000,000, and shares repurchased with those proceeds = $10,000,000 / $25 = 400,000. Incremental shares = 1,000,000 - 400,000 = 600,000.
Diluted share count = 10,000,000 + 600,000 = 10,600,000, so diluted EPS = $4,000,000 / 10,600,000 = $0.38 per share. The dilution is about $0.02 per share, roughly 5.7% below the basic figure, and that is the number a careful analyst will use in a valuation multiple.Case study
Seen in the real world.
Verity Loom Systems is a fictional company used here purely for illustration. It floated three years ago and has since granted options generously to attract engineering talent, without the board ever seeing the cumulative effect in one place.
At the fourth annual results meeting the audit committee asked a simple question: what is the gap between basic and diluted earnings per share, and where is it heading? The finance team came back with a schedule showing basic EPS of $0.40, diluted EPS of $0.38 and, on the current grant rate, a projected gap of more than 12% within three years.
The illustrative board response was to cap annual grants as a percentage of issued shares and to introduce performance conditions so that options only vest if earnings targets are met. Nothing about the accounting changed, but for the first time the directors were managing dilution deliberately rather than discovering it in the notes to the accounts.
Watch out
Common mistakes.
- Ignoring diluted earnings per share because the instruments have not converted yet. The whole purpose of the figure is to show the effect before it lands in the reported share count.
- Adding every option and convertible into the diluted count. Anti-dilutive instruments must be excluded, and for options only the net shares after the assumed buyback are counted.
- Forgetting to adjust profit when a convertible bond is included. If conversion is assumed, the interest the company would no longer pay must be added back to earnings, net of tax.
Questions
People also ask.
What is the difference between basic and diluted earnings per share?
Basic uses only shares actually in issue, while diluted also includes the shares that would exist if dilutive convertible instruments and options were exercised.
Can diluted earnings per share be higher than basic?
No, because any instrument that would increase the figure is anti-dilutive and is excluded from the calculation.
Do out-of-the-money options still matter?
They are excluded from the diluted count while the share price is below the exercise price, but they can become dilutive again if the price recovers.
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