Overview

The reason that analysts and investors calculate diluted earnings per share, also called diluted EPS, is that basic earnings
per share may overstate the actual amount of earnings per share that a common shareholder is entitled to.

Companies frequently have dilutive securities outstanding like stock options, rights to purchase common shares, bond
and preferred stock that can be converted to common shares, and warrants that will increase the total number of shares
outstanding when converted. Dilutive securities are securities that are not common stock but can be converted to
common stock if the holder exercises that option. If converted, dilutive securities effectively increase the weighted
number of shares outstanding, which decreases EPS.

Convertible preferred stock, stock options, and convertible bonds are common types of dilutive securities. Convertible
preferred stock is a preferred share that can be converted to a common share at any time. Stock options, a common
employee benefit, grant the buyer the right to purchase common stock at a set price at a set time. Convertible bonds are
similar to convertible preferred stock as they are converted to common shares at the prices and times specified in their
contracts. All of these securities, if exercised, would increase the number of shares outstanding and decrease EPS.

Since the conversion of option into shares would not add any additional net income to the business, the increased share
count makes the conversion dilutive. Options may have been granted to employees, for example, that are in-the-money
(that is, there is a reasonable chance that they will indeed convert into common shares) but have not been converted
yet. If options are in-the-money, they should be accounted for in a diluted EPS calculation.

Dilutive securities are not current outstanding shares, but they do have the possibility of becoming outstanding shares.
This in turn means that diluted EPS can change when the company's share price changes (because the chance of
conversion often rises and falls with the stock price). Although the possibility of all of the dilutive securities being called
at once is impossible, it would drastically reduce the basic earnings per share because the number of outstanding shares
would skyrocket.

That is why the diluted EPS calculation is often calculated in the notes of the financial statements. This shows investors
and creditors what would happen if all the stock options and conversions were turned into common shares overnight. It
also shows the capital structure of the organization.

DILUTED EARNINGS PER SHARE

Diluted EPS is a profitability calculation that measures the amount of income each share will receive if all of the dilutive
securities are realized. In other words, it shows the effect of dilutive securities on the basic earnings per share.

The basic earnings per share formula takes the difference between net income and preferred dividends and divides it by
the average outstanding common stock. This calculates the amount of income that is available to the current common
shareholders of the company. The key word in that sentence is current. It only reflects the current outstanding shares.

Diluted EPS is essentially the earnings made on every share of a public company that is calculated assuming that all the
securities that are convertible were duly exercised. Instead of taking only the existing common stock into consideration,
Diluted Earnings Per Share assumes that all the securities including convertible bonds, convertible preferred shares,
stock options, warrants as well as other things, which can be altered into common stock is altered actually. Diluted EPS
measures a firm’s earnings performance, if the firm’s unexercised employee stock options, convertible preferred shares,
convertible debt, and warrants are exercised.

To calculate the diluted EPS, we need to know the net income, the preferred dividends, the convertible preferred
dividend, the tax rate, the weighted average of dilutive common shares, the convertible preferred shares, the
convertible debt and the unexercised employee stock options.
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The diluted EPS formula uses the basic EPS calculation and adds the dilutive securities to the common shares in the
denominator. In order to calculate diluted EPS, one must include the impact of all the common shares that are dilutive.
Thus, it is basically the company’s net income that needs to be divided by the total sum of a company’s average shares
as well as other instruments that are convertible. While, the net income of a company can be acquired through the
income statement prepared by it, the average share of a company is basically the weighted common shares average for
the entire year. Thus, the weights of each and every factor typically include the duration for which each common share
would have remained outstanding.

For example, if an entity has hundred common shares that are outstanding for a period of nine months
and hundred and twenty common shares, which are outstanding for three months. The respective
weights of nine months as well as three months would stand at .75 and .25. This further represents
three-fourth of a year and one-fourth of a year. Therefore, the formula would be .75 (100) plus .25 (120)
that would be equal to a weighted average of hundred and five common shares for the complete year.

Compared to the EPS, the diluted EPS is always lower.

Examples

1. Assume company PKL had a net income of P50 million over the last fiscal year but did not pay any dividends and has
common shares outstanding of 15 million. Assume company PKL has employee stock options that could be
converted to 1 million common shares and convertible preferred shares that could be converted to 3 million
common shares.

Company PKL's resulting EPS is

Net Income−Preferred Dividends
EPS=
End of Period Shares Outstanding

50,000,000−0
EPS=
15,000,000

EPS=3.33

The resulting diluted EPS for company PKL is

Net income−Preferred dividends

Diluted EPS=
WASO+CDS
Where:
WASO – Weighted average shares outstanding
CDS – Conversion of dilutive securities
Dilutive securities – In-the-money options, warrants and other securities

50,000,000−0
Diluted EPS=
15,000,000+1,000,000+3,000,000

Diluted EPS=2.63

Generally, if a company has convertible securities, the diluted EPS is less than its basic EPS.

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2. Lockdown earns a net profit of P200,000, and it has 5,000,000 common shares outstanding that sell on the open
market for an average of P12 per share. In addition, there are 300,000 options outstanding that can be converted to
Lockdown’s common stock at P10 each.

Lockdown’s basic earnings per share is P200,000 ÷ 5,000,000 common shares, or P0.04 per share. Lockdown’s
controller wants to calculate the amount of diluted earnings per share. To do so, he follows these steps:
a. Calculate the number of shares that would have been issued at the market price. Thus, he multiplies the 300,000
options by the average exercise price of P10 to arrive at a total of P3,000,000 paid to exercise the options by
their holders.
b. Divide the amount paid to exercise the options by the market price to determine the number of shares that
could be purchased. Thus, he divides the P3,000,000 paid to exercise the options by the P12 average market
price to arrive at 250,000 shares that could have been purchased with the proceeds from the options.
c. Subtract the number of shares that could have been purchased from the number of options exercised. Thus, he
subtracts the 250,000 shares potentially purchased from the 300,000 options to arrive at a difference of 50,000
shares.
d. Add the incremental number of shares to the shares already outstanding. Thus, he adds the 50,000 incremental
shares to the existing 5,000,000 to arrive at 5,050,000 diluted shares.

Based on this information, the controller arrives at diluted earnings per share of P0.0396, for which the calculation
is:

Net profit
Diluted EPS=
Diluted Shares

P 200,000
Diluted EPS=
5,050,000

Diluted EPS=.0396
3. The net income of company ABC is P4,000,000. In the beginning of 2019, the company had 3,000,000 shares
outstanding, but in the second half, the shares outstanding increased to 4,200,000. Furthermore, the company has
the following:
Unexercised employee stock options P250,000
Convertible preferred shares 100,000
Convertible debt 125,000
Convertible debt dividend 20,000
Preferred dividends 0
The tax rate is 30%
The interest is P5,000 annually.

As the financial analyst in the company ABC, you are asked to calculate the diluted EPS and compare it to the EPS.
 The first step is to calculate the weighted average of dilutive common shares, which is the product of the
outstanding shares multiplied by the weight of the reporting period. In this case, the first half of the year was
covered by 3,000,000 shares outstanding and the second half of the year was covered by 4,200,000 shares
outstanding. Therefore, the weighted average of the dilutive common shares is

Weighted average of diluted common shares= (.5 X 3,000,000 ) +(.5 X 4,200,000)

Weighted average of diluted common shares=3,600,000

Now, the firm’s diluted EPS is calculated as follows:

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 ( Net income−Preferred dividends ) +Convertible preferred dividend +(Convertible debt interest X [ 1−t ] )
Weighted average of dilutive common shares +Unexercised employee stock options+ Convertible preferred shares+Conver

P 4,000,000+ P20,000 X (1−.30)

Diluted EPS=
P 3,600,000+250,000+100,000+125,000
P 4,000,000+ P 14,000
Diluted EPS=
P 4,075,000

Diluted EPS=.985

Net Income−Preferred Dividends

EPS=
End of Period Shares Outstanding

P 4,000,000−0
EPS=
P 3,600,000

EPS=1.11

Compared to the firm’s EPS of 1.11, the diluted EPS is lower to allow a better dilution of earnings over the
shareholder value.

Here are a number of additional situations that could impact the calculation of diluted EPS:

Most advantageous exercise price. When you calculate the number of potential shares that could be issued, do so using
the most advantageous conversion rate from the perspective of the person or entity holding the security to be
converted.

Settlement assumption. If there is an open contract that could be settled in common stock or cash, assume that it will be
settled in common stock, but only if the effect is dilutive. The presumption of settlement in stock can be overcome if
there is a reasonable basis for expecting that settlement will be partially or entirely in cash.

Effects of convertible instruments. If there are convertible instruments outstanding, include their dilutive effect if they
dilute EPS. You should consider convertible preferred stock to be anti-dilutive when the dividend on any converted
shares is greater than basic earnings per share. Similarly, convertible debt is considered anti-dilutive when the interest
expense on any converted shares exceeds EPS.

Option exercise. If there are any dilutive options and warrants, assume that they are exercised at their exercise price.
Then, convert the proceeds into the total number of shares that the holders would have purchased, using the average
market price during the reporting period. Then use in the diluted EPS calculation the difference between the number of
shares assumed to have been issued and the number of shares assumed to have been purchased.

Put options. If there are purchased put options, only include them in the diluted EPS calculation if the exercise price is
higher than the average market price during the reporting period.

Written put options. If there is a written put option that requires a business to repurchase its own stock, include it in the
computation of diluted EPS, but only if the effect is dilutive.

Call options. If there are purchased call options, only include them in the diluted EPS calculation if the exercise price is
lower than the market price.
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Compensation in shares. If employees are awarded shares that have not vested or stock options as forms of
compensation, treat these grants as options when calculating diluted EPS. Consider these grants to be outstanding on
the grant date, rather than any later vesting date.