What it means
Convertible instruments are a promise of future shares, and future shares dilute the ownership of existing shareholders. Reporting only basic earnings per share would flatter a company that has funded itself with convertibles rather than plain equity.
Diluted earnings per share exists to close that gap, and the if-converted method is how convertibles are folded into it. The calculation makes two adjustments that pull in opposite directions.
The share count rises by the number of ordinary shares the instruments would create on conversion, which reduces earnings per share. At the same time reported profit rises, because on conversion the company would no longer pay interest on the bonds or dividends on the preference shares.
For convertible bonds the interest add-back is net of tax, since the interest was a tax-deductible expense that would disappear on conversion. For convertible preference shares no tax adjustment is needed, because preference dividends are paid out of after-tax profit.
Getting this distinction right is the single most common technical error in the calculation. Not every convertible is included.
If adding the extra shares and the extra earnings actually increases earnings per share, the instrument is antidilutive and must be excluded, because the rules permit reporting dilution but never an improvement. Each convertible is tested separately and instruments are ranked from most dilutive to least when several exist.
Options and warrants are handled by a different technique, the treasury stock method, which assumes the proceeds from exercise are used to buy back shares at the average market price. A company with a mixed capital structure therefore builds its diluted share count from both methods at once.
Where conversion actually took place part way through the year, the new shares are counted from the conversion date and the if-converted assumption applies only to the earlier part of the period.
In practice
Real-world examples.
Example
A biotechnology company funded by a $30 million convertible note reports basic EPS of $0.42 and diluted EPS of $0.31 after applying the if-converted method. Analysts anchor on the diluted figure because conversion is highly likely given where the share price is trading.
Example
A manufacturer holds convertible preference shares paying $800,000 of annual dividends and convertible into 1,200,000 ordinary shares. Adding back the dividends and the shares raises EPS rather than lowering it, so the instrument is antidilutive and is excluded from the diluted calculation.
Example
A retailer's convertible notes are converted in September. Diluted EPS for the year applies the if-converted assumption for the first eight months and includes the actual new shares on a weighted basis for the remainder.
Formula
Calculation
Diluted EPS = (Net Income + After-Tax Interest on Convertible Debt + Convertible Preference Dividends) / (Basic Weighted Average Shares + Shares from Assumed Conversion)
A company reports net income of $4,000,000 and has 4,000,000 ordinary shares in issue throughout the year. It also has $10,000,000 of 6% convertible notes outstanding, convertible into 500,000 ordinary shares. The corporate tax rate is 25%.
Basic EPS = $4,000,000 / 4,000,000 shares = $1.00 per share.
Annual interest on the notes = $10,000,000 x 6% = $600,000.
After-tax interest add-back = $600,000 x (1 - 0.25) = $600,000 x 0.75 = $450,000.
Adjusted earnings = $4,000,000 + $450,000 = $4,450,000.
Adjusted share count = 4,000,000 + 500,000 = 4,500,000 shares.
Diluted EPS = $4,450,000 / 4,500,000 = $0.99 per share, rounded to the nearest cent.
Because $0.99 is below the basic figure of $1.00, the notes are dilutive and must be included. The dilution is a little over 1%, which sounds small but would be far larger if the conversion ratio were more generous or the coupon lower.Case study
Seen in the real world.
Arbor Health Systems is a fictional listed care provider used here for illustrative purposes. It raised $10,000,000 through 6% convertible notes to fund a chain of clinics, and management presented the deal internally as cheaper than equity because the coupon looked modest against the cost of issuing shares outright.
At the following year end the finance team ran the if-converted calculation. Net income of $4,000,000 across 4,000,000 shares gave basic EPS of $1.00, while the diluted calculation produced $4,450,000 over 4,500,000 shares, or $0.99. The dilution was mild, but the note terms allowed the conversion ratio to increase if the share price fell below a trigger level.
The team modelled that scenario and found that a lower share price would push conversion to 900,000 shares, giving $4,450,000 over 4,900,000 shares, or roughly $0.91 per share. In this illustrative story the board added a covenant test to its financing policy requiring every future convertible to be modelled at its worst-case conversion ratio before approval, rather than at the headline coupon alone.
Watch out
Common mistakes.
- Forgetting to add back the interest saved on convertible debt, which overstates dilution by increasing the share count without the matching increase in earnings.
- Adding back convertible bond interest gross rather than net of tax, which overstates adjusted earnings and understates the true dilution.
- Including an antidilutive instrument in the calculation, when accounting rules require any conversion that would raise earnings per share to be excluded.
Questions
People also ask.
Why does diluted EPS matter more than basic EPS?
Because it shows what each share would earn if all the promises of future shares were honoured, which is closer to the position an incoming investor actually buys into.
Does the if-converted method apply to share options?
No, options and warrants use the treasury stock method, which assumes exercise proceeds are used to repurchase shares at the average market price.
What happens if the company makes a loss?
Convertibles are generally antidilutive in a loss-making period because adding shares would reduce the loss per share, so they are usually excluded and diluted loss per share equals basic loss per share.
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