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Diluted EPS and the Capital Structure

Diluted EPS and the Capital Structure

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Published by Carneades
Discussion of Diluted Earnings-per-Share; how it differs from Basic EPS, and how it is a particularly useful metric when analyzing firms with complex capital structures.
Discussion of Diluted Earnings-per-Share; how it differs from Basic EPS, and how it is a particularly useful metric when analyzing firms with complex capital structures.

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Published by: Carneades on Nov 19, 2009
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Although the financial media's reporting centers almost entirely on a corporation's reportedbasic earnings-per-share (EPS), most analysts have historically paid attention to a different lineon the income statement: Diluted Earnings per Share. Diluted EPS takes into account thepotential dilutive effect that would ensue if holders of the firms preferred stock and bonds wereto convert their stake into common equity. This possibility theoretically exists wheneverinvestors purchases securities that include a conversion option. Usually there is some sort ofmarket based trigger point, but ultimately those details will be contained on the face of thepreferred stock certificate, or in the bond covenants. For the sake of simplicity, let's say thatCompany X earned $1000 in a given quarter, and there are 1000 shares outstanding, resultingin quarterly Basic EPS of $1/share. However, let's assume that Company X has also financeditself via 500 shares of convertible preferred stock which give holders the right to convert eachpreferred share into 2 shares of common equity. Assuming that all preferred holders exercisedthat option, Company X would record 2000 outstanding shares of common stock, and wouldonly have earned 50 cents/share for the same quarter. This hypothetical example is ratherextreme for the purposes of making a point; below is a chart showing Basic v Diluted EPSduring the most recently reported quarter for 7 large firms:
Corporations must disclose both basic and diluted EPS on the income statement, however theactual calculation is below for those who must know:Diluted EPS = (Net Income - Preferred Dividends) / (Weighted Average # of Common SharesOutstanding + Additional Shares Due to Dilutive Securities)Arithmetically, we can see that the dilutive effect increases the denominator, reducing theamount of net income available to each shareholder. In many firms with simple capitalstructures, the basic and diluted EPS numbers will be identical. However, firms that utilize morecomplex financing instruments generally have more potential for dilutive equity conversions.Going forward, I would expect Diluted EPS to continue to gain significance, especially withregards to analysis of financial corporations. As banks struggle to refinance trillions of dollarsworth of debt, the use of convertible options should become more popular for a couple ofreasons. First, a conversion option represents value to the investor and additional capital for theborrower. Second, if the conversion option is tied to a regulatory trigger like TCE ratios, then theborrower is essentially selling an automatic equity boosting instrument for times of marketdistress. If things play out like I anticipate regarding convertible debt, the gap between basic anddiluted EPS will grow further. Equity investors need to monitor these developments to insure

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