What it means
Basic earnings per share divides profit by the shares in issue today. Diluted earnings per share asks a harder question: what would each share earn if every promise the company has already made about future shares were honoured at once?
The gap between the two numbers is the dilution, and its size tells a story. A company that pays its staff heavily in options, or that funded itself with convertible debt, can show a comfortable basic figure and a noticeably thinner diluted one.
Accounting rules require listed companies to present both numbers on the face of the income statement. Only instruments that would reduce earnings per share are included, which is why deeply out-of-the-money options are excluded while in-the-money ones are counted.
The mechanics for options follow the treasury stock method. The company is assumed to issue the option shares and immediately spend the exercise proceeds buying shares back at the average market price, so only the net new shares increase the count.
For a non-specialist the practical use is comparison and expectation setting. If you are valuing a business on a multiple of earnings per share, using the basic figure for a company with heavy option grants will make it look cheaper than it really is.
In practice
Real-world examples.
Example
A clinical-stage biotech reports a loss of $0.45 per share. Because adding option shares would make the loss per share look smaller, the options are excluded as antidilutive and diluted loss per share is also $0.45.
Example
A listed retailer earns $60,000,000 with 25,000,000 shares, giving basic EPS of $2.40. Convertible bonds that would add 3,000,000 shares and save $1,800,000 of after-tax interest produce diluted EPS of $61,800,000 / 28,000,000 = $2.21.
Example
A technology board reviews a proposed grant of options while earnings are $40,000,000 on 40,000,000 shares, or $1.00 basic. The grant would add roughly 1,200,000 net new shares, cutting diluted EPS to $40,000,000 / 41,200,000 = $0.97, and the remuneration committee decides the cost is acceptable.
Think of it
“Diluted EPS shows earnings per share if all options and convertibles became stock-maximum dilution.
Formula
Calculation
Diluted EPS = (Net income - Preferred dividends) / Diluted weighted average shares
Diluted weighted average shares = Basic weighted average shares + Net new shares from dilutive instruments
A software company earns net income of $12,600,000 and pays $600,000 of preferred dividends, leaving $12,000,000 for ordinary shareholders. With 10,000,000 basic weighted average shares, basic EPS is $12,000,000 / 10,000,000 = $1.20.
It also has options over 1,500,000 shares at an exercise price of $10, while the average market price for the year was $25. The proceeds of 1,500,000 x $10 = $15,000,000 would buy back $15,000,000 / $25 = 600,000 shares, so the net new shares are 1,500,000 - 600,000 = 900,000. Adding 1,100,000 unvested share awards gives 2,000,000 extra shares and a diluted count of 10,000,000 + 2,000,000 = 12,000,000.
Diluted EPS is therefore $12,000,000 / 12,000,000 = $1.00. The dilution is $1.20 - $1.00 = $0.20 per share, which is $0.20 / $1.20 = 16.7% below the basic figure.Case study
Seen in the real world.
Hollowbrook Software is an entirely fictional listed company used here as an illustrative example. It had grown quickly by paying below-market salaries topped up with generous share options, a sensible way to conserve cash that nobody had translated into a share count.
Its first annual report as a listed business showed basic EPS of $0.90 and diluted EPS of $0.72, a difference of $0.18 or 20%. Investors who valued the company at twenty times basic earnings were pricing it at $18.00 a share, while the same multiple on diluted earnings gave $14.40, and the market unsurprisingly settled closer to the lower number.
Management had not misled anyone, since both figures were properly disclosed. But the board had never tracked the option pool as a percentage of shares, and in this illustrative case it introduced an annual dilution budget so that future grants were approved against a share count rather than against a cash cost of zero.
Watch out
Common mistakes.
- Quoting basic EPS in investor materials while the market prices the business on diluted EPS, which creates an avoidable gap between expectation and valuation.
- Assuming every option in existence is added to the share count, when only in-the-money instruments are dilutive and the treasury stock method nets off the exercise proceeds.
- Reading a widening gap between basic and diluted EPS as an accounting change, when it usually means new options, convertibles or share awards have been issued.
Questions
People also ask.
Can diluted EPS ever be higher than basic EPS?
No, by construction it is equal to or lower than basic EPS, because instruments that would increase it are excluded as antidilutive.
Why is diluted EPS the same as basic EPS for a loss-making company?
Adding shares would reduce the reported loss per share, which is antidilutive, so the potential shares are left out entirely.
Which figure should be used in a price to earnings ratio?
Diluted EPS, since it reflects the share count an investor would realistically end up sharing profits with over time.
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