What is Diluted EPS?
Diluted EPS measures the residual net profits distributable to each share of total common equity outstanding.
Unlike the basic EPS metric, the calculation of diluted EPS accounts for the share count impact from the exercise of potentially dilutive securities such as options, warrants, and convertible debt or equity instruments.
How to Calculate Diluted EPS?
The concept of diluted shares outstanding can be equated to a pie, of sorts – if more slices were cut to accommodate for an increase in the number of people sharing the pie, that means that the size of each slice would decrease for each additional person sharing the pie.
The formula used to calculate the diluted EPS of a company is nearly identical to the basic EPS – in which net income upon adjusting for the payout of preferred dividends is divided by the total number of common shares outstanding (but post-dilution, this time).
If the company has issued preferred dividends in the current period, we must remove the value of those preferred dividends from net income.
In effect, we are isolating the earnings attributable to just common equity shareholders, which should NOT be inclusive of preferred equity holders.
Diluted EPS Formula
The formula for calculating diluted EPS is as follows.
The notable difference between the diluted and basic EPS is that the common share count is adjusted for the exercising of dilutive securities. In effect, that added step increases the number of common shares outstanding.
Under the treasury stock method (TSM), if an option tranche is “in-the-money” and profitable to execute, the option (or related security) is assumed to be executed.
Then, the proceeds received by the company from the issuance is assumed to be used to repurchase shares at the current share price in an attempt to reduce the dilutive impact of the new shares.
But while it was formerly standard practice for just ITM securities to be included in this calculation in the past, it has increasingly become more common to take a more conservative approach by including all (or the majority) of issued dilutive securities, regardless of whether they are in or out of the money.
The calculation of EPS – regardless of whether it is done on a basic or diluted basis – should use the weighted average of common shares outstanding, i.e. the average of the beginning and end of period balance.
But considering how we’re looking at only one single year for purposes of simplicity, we can just assume that the common shares figure refers to the weighted average share count.
Diluted EPS Calculator
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
1. Income Statement Assumptions
Suppose that for the latest fiscal year, the company in our hypothetical scenario has the following financial data:
- Net Income = $260mm
- Preferred Dividends = $10mm
In order to have a baseline for comparability, we’ll start by calculating the basic EPS to see the EPS pre-dilution.
Using those two stated assumptions, we can calculate the “Net Earnings for Common Equity” (i.e. the net income attributable to solely common shareholders, excluding preferred shareholders) by deducting the value of the preferred dividend payout from net income.
The net earnings for common equity holders come out to $250mm.
- Net Earnings for Common Equity = $260mm Net Income – $10mm Preferred Dividends = $250mm
The remaining step is to calculate the basic EPS by dividing the net earnings by the pre-dilution common share count.
- Basic Earnings Per Share (EPS) = $250mm Net Earnings for Common Equity ÷ 200mm Common Shares
- Basic Earnings Per Share (EPS) = $1.25
2. Diluted EPS Calculation Example
With our baseline basic EPS calculation complete, we can now continue to calculate diluted EPS.
One key assumption is that the latest closing share price is $50.00, which will come in later when we perform the treasury stock method (TSM).
In terms of the potentially dilutive securities issued in the past by our company, there are three tranches of options outstanding.
- Option Tranche 1 → 25mm Shares @ $20.00 Strike Price
- Option Tranche 2 → 35mm Shares @ $25.00 Strike Price
- Option Tranche 3→ 45mm Shares @ $30.00 Strike Price
All three options tranches are “in-the-money” and following the TSM, each tranche is assumed to be exercised by the holders since there is an economic incentive (i.e. in all cases, the strike price is below the latest closing share price).
In the next step, we’ll assume that using the proceeds received from the holders, as many shares as possible are repurchased to limit the dilutive impact on the company’s equity ownership.
The net dilutive impact is 51mm – that means despite all the repurchases by the company, the share count is still set to increase by 51mm new common shares from the exercise of options.
- Fully Diluted Common Shares Outstanding = 200mm Common Shares + 51mm = 251mm
We then divide the $250mm of net earnings for common equity by our new dilution-adjusted common share count to get our diluted EPS.
- Diluted Earnings per Share (EPS) = $250mm Net Earnings ÷ $251mm Fully Diluted Common Shares
- Diluted EPS = $1.00
3. Diluted EPS Ratio Analysis Example
Our diluted EPS of $1.25 compares to the basic EPS of $1.00 – with a net differential of $0.25 – due to the incorporation of the dilutive impact of options, warrants, mezzanine instruments, etc.
To conclude our tutorial on calculating diluted EPS, a screenshot of our completed output sheet has been posted below.
Under our model assumptions, the relationship should be apparent that the greater the dilutive impact, the more of a negative impact there’ll be on diluted EPS as compared to basic EPS (and vice versa).
What is a Good Diluted EPS?
All else being equal, the greater the net dilutive impact from these securities, the more downward pressure there is going to be on the diluted EPS figure (and the valuation of the firm).
Generally, higher diluted EPS figures – assuming the company is mature with a track record of profitability – should obtain higher valuations from the market (i.e. investors are more willing to pay a premium for each share of equity).
In all likelihood, the company has carved out a sustainable competitive advantage (i.e. “edge”) and is considered to be a market leader – i.e. holds a substantial percentage of the total market share.
If that presumption is true, the longevity of the company in question (and its future prospects) are likely optimistic, as the company has greater flexibility in terms of:
- Raising Prices on Products / Services (i.e. Pricing Power)
- Funding Expansion Plans with Excess Cash
- Extending Payables with Suppliers
- Diversification of Revenue Sources
- Acquiring Smaller-Sized Competitors
For the most part, the market is going to attach higher valuations to leading companies with higher net profits (and projected EPS), or even companies with the potential to achieve higher net profits someday (i.e. companies with future upside from margin expansion).
As a result, companies earlier on in their lifecycles often obtain significantly higher valuations despite their low-profit margins (or even unprofitable), which is due to the market’s belief that the company can someday become profitable.
Higher EPS figures, especially if adjustments are properly made for dilutive securities, can be an accurate signal that the company is generating higher quality free cash flows at higher margins.
An increase in FCFs directly leads to more cash that can be used to increase growth, as well as increase the defensibility of current market share (i.e. fending off smaller players or new entrants).