What it means
Basic earnings per share divides profit by the weighted average number of ordinary shares actually in issue during the period. Diluted earnings per share keeps the same profit figure, adjusted where needed, but adds the shares that could be created by options, warrants, convertible bonds and convertible preference shares.
The word dilution captures the effect precisely: the same profit spread across more shares means less profit per share. A company with lots of employee options outstanding will show a diluted figure noticeably below its basic one, and the gap is a useful measure of how much of the business future issuance has already promised away.
The standard mechanism for options and warrants is the treasury stock method. It assumes the options are exercised, that the company receives the exercise money, and that it immediately uses that money to buy back shares at the average market price, so only the net extra shares count as dilutive.
Convertible bonds are handled differently, using the if-converted method. The bond is assumed to convert into shares, which increases the share count, and the interest the company would no longer pay is added back to profit, which raises the numerator as well.
One rule catches people out: instruments that would increase earnings per share are anti-dilutive and are excluded from the calculation. Diluted earnings per share can therefore never be higher than basic earnings per share, and if you see that in a set of accounts, something has gone wrong.
In practice
Real-world examples.
Example
A technology company that pays a large part of its staff in share options reports basic EPS of $2.40 and diluted EPS of $2.05. An analyst uses the diluted figure for valuation, on the basis that the options are a real cost of running the business that has simply been paid in shares.
Example
A manufacturer issues a convertible bond to fund a new plant. In the year of issue, diluted EPS falls below basic EPS as the potential conversion shares enter the calculation, even though not a single new share has yet been created.
Example
A loss-making biotechnology firm reports the same figure for basic and diluted EPS. Because adding shares to a loss would make the loss per share smaller, the potential shares are anti-dilutive and must be left out.
Formula
Calculation
Diluted EPS = profit available to ordinary shareholders / (weighted average shares in issue + dilutive potential shares).
A listed engineering group reports profit available to ordinary shareholders of $12,600,000 and a weighted average of 10,000,000 ordinary shares in issue. Basic EPS = $12,600,000 / 10,000,000 = $1.26 per share.
The group has 1,500,000 employee share options outstanding with an exercise price of $20, and the average market price during the year was $30. Applying the treasury stock method: cash received on exercise = 1,500,000 x $20 = $30,000,000, and shares that could be bought back with it = $30,000,000 / $30 = 1,000,000 shares.
Net dilutive shares = 1,500,000 - 1,000,000 = 500,000. Diluted share count = 10,000,000 + 500,000 = 10,500,000.
Diluted EPS = $12,600,000 / 10,500,000 = $1.20 per share. The dilution is $1.26 - $1.20 = $0.06 per share, a reduction of about 4.8% against the basic figure.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Fenmarsh Robotics, an invented listed company, told investors it had grown earnings per share from $0.90 to $1.05, a rise of about 17%, and the share price responded well.
A closer reading of the accounts showed a different picture on the diluted line, where EPS had moved from $0.88 to $0.91. The company had funded two acquisitions partly with convertible loan notes and had also expanded its employee option scheme, so the potential share count had grown by nearly 15% over the year.
In this fictional case the underlying business really had grown, but far less of that growth belonged to existing shareholders than the headline basic figure implied. The illustrative point is that the gap between basic and diluted EPS, and the direction that gap is moving, often says more than either number on its own.
Watch out
Common mistakes.
- Quoting basic EPS in investor materials while a large option pool sits outstanding, which flatters performance and invites an uncomfortable question later.
- Adding every outstanding option to the share count, when the treasury stock method only counts the net shares left after the assumed buyback with exercise proceeds.
- Comparing one company's diluted EPS with another's basic EPS, which is not a like-for-like comparison and usually favours the wrong business.
Questions
People also ask.
Why is diluted EPS always lower than or equal to basic EPS?
Because any instrument that would raise EPS is classed as anti-dilutive and excluded, so the calculation can only ever reduce the figure or leave it unchanged.
Are out-of-the-money options included?
No, options with an exercise price above the average market price for the period are anti-dilutive and are left out of the calculation.
Which figure should I use when valuing a company?
Diluted EPS is the more prudent basis for valuation, since it reflects the claims on future profit that have already been granted even though the shares do not exist yet.
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