Diluted Earnings Per Share

Basic earnings per share divides the profit attributable to ordinary shareholders by the weighted average number of ordinary shares in issue during the period. It answers the question of how much the company earned for each share that exists.

But many companies have issued instruments that will or may become shares: options granted to employees, warrants issued to investors or lenders, bonds and preference shares convertible into ordinary shares. If those instruments are exercised or converted, the same profit will be spread across more shares, and each existing share's slice will shrink.

Diluted earnings per share measures the slice after that shrinkage, so that shareholders can see the earnings per share they are actually entitled to once all the outstanding claims are honoured. The calculation adjusts both the numerator and the denominator for each dilutive instrument.

For options and warrants, the treasury stock method is used: the instruments are assumed exercised at the start of the period, the cash the company would receive is assumed to be used to buy back shares at the average market price for the period, and only the net increase in shares, exercised shares less shares repurchased, is added to the denominator. Options whose exercise price is above the average market price are out of the money, would not be exercised, and are excluded.

For convertible bonds and convertible preference shares, the if-converted method is used: the instruments are assumed converted at the start of the period, the shares issued on conversion are added to the denominator, and the interest or preference dividends that would no longer be paid, net of tax, are added back to the numerator. Only dilutive instruments are included.

An instrument is dilutive if including it reduces earnings per share; if its inclusion would raise earnings per share, it is antidilutive and left out, so that the diluted figure never exceeds the basic. This can happen with a convertible whose interest saving per new share exceeds basic earnings per share, or with any instrument when the company has a loss.

The standard procedure ranks the instruments from most to least dilutive, by their incremental earnings per share, and adds them in that order, stopping when the next one would raise the figure. The gap between basic and diluted earnings per share is itself informative.

A small gap means few outstanding claims; a large one means the company has granted or issued substantial rights over its future shares, typically through employee option schemes in growth companies or through convertible financing in companies that could not raise straight debt or equity on acceptable terms. The gap is sometimes called the overhang, and it tells existing shareholders how much of the company's future earnings has already been promised to others.

For a valuation, the diluted share count is the right one to use, since a buyer of the whole company would have to satisfy the options and convertibles. The figure has limits.

It is calculated on the period's average share price and earnings, so it says nothing about instruments that are out of the money today but might be in the money later. It assumes conversion at the start of the period, which is a convention rather than a prediction.

And it does not capture instruments the company may issue in future, which is why analysts also look at the company's history of issuance and the size of its unallocated option pool. But as a statement of the claims that already exist, it is the figure that matters, and companies that emphasise basic earnings per share when the diluted figure is materially lower are drawing attention to the wrong number.