What it means
Every listed company reports two earnings per share figures. Basic EPS divides profit by the shares that actually exist today, while diluted EPS divides the same profit by a larger count that assumes outstanding options, warrants, convertible bonds and unvested share awards have all turned into real shares.
The gap between the two matters because those instruments are genuine claims on future profit. If a software company has issued staff options over 15% of its share base, the slice of profit each existing shareholder can claim is quietly smaller than the basic figure suggests.
The standard way to count option dilution is the treasury stock method. It assumes the options are exercised, the company collects the exercise money, and immediately spends that money buying its own shares back at the average market price, so only the leftover shares count as dilution.
Convertible bonds are handled differently, using the if-converted method. The bond is treated as though it had already become shares, so the interest the company would have paid is added back to profit and the new shares are added to the count.
A useful rule is that an instrument only counts if it makes EPS worse. Options priced above the current market price are ignored because exercising them would make no sense, which is why the diluted figure can move around as the share price changes.
In practice
Real-world examples.
Example
A cloud accounting firm reports basic EPS of $1.20 and diluted EPS of $1.02. The 15% gap comes almost entirely from restricted share units granted during a hiring push, and the board uses the diluted figure when setting its own bonus targets so management is not rewarded for issuing paper.
Example
A biotechnology company issues a $50,000,000 convertible bond to fund a trial. Because the bond converts at $18 and the shares now trade at $30, the auditors add the conversion shares to the diluted count, and diluted EPS falls from $0.44 to $0.36 even though nothing about the operating business changed.
Example
A retail chain buys back 4,000,000 shares over a year and cancels a legacy option pool. Its diluted share count falls faster than its basic count, so diluted EPS grows 11% while profit grows only 6%, and the chief financial officer explains the difference clearly in the results call.
Think of it
“Diluted EPS includes all potential shares-conservative earnings measure.
Formula
Calculation
Diluted EPS = (Net profit - preferred dividends) / (Weighted average ordinary shares + dilutive potential shares)
A software company earns a net profit of $12,000,000 and pays no preferred dividends. It has 40,000,000 weighted average ordinary shares, so basic EPS is $12,000,000 / 40,000,000 = $0.30.
The company also has 2,000,000 employee share options with an exercise price of $10, and the average market price during the year was $25. Under the treasury stock method the company would collect 2,000,000 x $10 = $20,000,000 of exercise proceeds, which buys back $20,000,000 / $25 = 800,000 shares. Net new shares are therefore 2,000,000 - 800,000 = 1,200,000.
Diluted share count = 40,000,000 + 1,200,000 = 41,200,000
Diluted EPS = $12,000,000 / 41,200,000 = $0.29 (unrounded $0.2913)
The options shave about one cent, or roughly 2.9%, off the headline earnings figure.Case study
Seen in the real world.
In this illustrative example, Lantern Freight Systems is a fictional logistics software business that listed two years ago and has grown profit steadily since. Its investor deck led with basic EPS of $0.75, and the founders were pleased that this beat their guidance of $0.70.
An analyst on the results call pointed out that diluted EPS was only $0.61, because the company had granted options and performance shares equal to nearly a fifth of its share base during the growth push. The share price fell 8% the next day, not because profit had disappointed, but because investors recalculated their valuation on the diluted number they had not been shown.
The finance team changed the reporting pack the following quarter. Diluted EPS now appears first on every slide, the option pool is disclosed with the assumed exercise prices, and the remuneration committee measures management on diluted growth so that issuing new shares carries a visible cost.
Watch out
Common mistakes.
- Treating diluted EPS as a worst-case scenario rather than the base case. For any company with a meaningful option pool, dilution is the normal path, not a remote risk.
- Adding the full number of option shares to the count. The treasury stock method nets off the shares the company could buy back with the exercise proceeds, so the dilution is smaller than the raw option count.
- Comparing one company's basic EPS with another's diluted EPS. The two are not on the same footing, and the comparison will favour whichever business happens to hand out more equity to staff.
Questions
People also ask.
Why can diluted EPS equal basic EPS?
If a company has no options, warrants or convertibles outstanding, or if all of them are priced above the market, there is nothing to add and the two figures are identical.
Does a loss-making company report dilution?
Not usually, because adding shares to a loss would make the loss per share look smaller, and accounting rules do not allow an instrument to improve the figure.
Which one should I use in a price to earnings ratio?
Use diluted EPS, since it reflects the claims on profit that already exist and gives a more conservative valuation multiple.
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