Basic EPS vs. Diluted EPS

View all blog posts under Articles

Earnings per share (EPS) is a measure of a company’s profitability and, by extension, a key indicator of its overall financial performance. In its most fundamental form (basic EPS), it indicates how much profit is assigned to each share of its common stock, which is valuable information for the firm’s investors.

A high EPS generally indicates that the company has the money either to pay out via dividends or reinvest in the business itself, whereas low EPS implies the opposite. Accordingly, how a company’s reported EPS squares with capital market expectations can cause significant fluctuations in its stock price.

An accountant working on EPS calculations.

In addition to basic EPS, there is also diluted EPS. This measure accounts for any convertible securities — such as employee stock options, convertible debt, convertible preferred shares, and warrants — that could be exercised, thereby diluting the EPS figure. Note that diluted EPS is by definition a theoretical figure, since it assumes something that hasn’t happened yet.

As an accountant, it is important to understand why these two EPS measures are widely used, as well as the particular circumstances under which each one might be scrutinized by capital markets. By earning an online Master of Accounting (MAc) from the University of Alabama at Birmingham (UAB), you will learn how to calculate both figures and what regulatory requirements exist for the disclosure of EPS information.

Basic vs. diluted EPS, explained

The formula for basic EPS is relatively straightforward. An accountant will subtract the company’s dividends for preferred stock from its net income, then divide that number by the weighted average of the common shares outstanding over the applicable accounting period. In calculating this weighted average, accountants must factor in any stock splits, stock dividends, share repurchases (also known as stock buybacks), and shares issued.

The basic EPS figure is in theory a great indicator of a company’s financial health and stock price. Indeed, high EPS implies that it is a worthwhile investment. However, there are some distinct limitations to EPS:

  • The existence of stock buybacks — which have surged since the 1980s — means that a company can reduce its total number of shares outstanding without actually increasing its net income, leading to a deceptively high EPS.
  • Mergers and acquisitions can distort EPS.
  • EPS does not provide any direct indication of a company’s debt position or financial leverage, two figures that any informed investor will want to know about. Plus, debt might be issued for buybacks.
  • Any adjustments in a company’s accounting policy — note that generally accepted accounting principles (GAAP) are not law — can result in changes in EPS.
  • EPS does not reveal how much capital was needed to generate the figure in question. In other words, two companies could have identical EPS numbers but radically different amounts of capital used, meaning that one made much better use of its resources.

Now let’s turn to diluted EPS. The formula is dividends for preferred stock subtracted from net income, divided by the sum of the weighted average of shares outstanding and the impact of all dilutive securities, including convertible shares, warrants, and stock options. As a result, diluted EPS is lower than EPS.

Diluted EPS can be complicated to calculate. For starters, an accountant would need to determine what it would cost to exercise the company’s issued options, based on the strike (exercise) price of the shares in question multiplied by the total number of options.

That figure would then be divided by the current market price of the stock, which would yield the number of shares that could be purchased with the value of the exercised options. Finally, subtracting that figure from the sum of the outstanding shares would provide the number of excess shares necessary for meeting the company’s obligations.

How EPS and diluted EPS are applied

The Financial Accounting Standards Board, which oversees GAAP, requires EPS under the provisions of Accounting Standards Codification (ASC) 260. ASC 260 has been amended many times and contains specifications for how EPS figures are calculated, presented, and disclosed. Moreover, many professional services firms have their own in-depth guides to EPS, including breakdowns of what each figure entails, discussions of individual types of convertible securities, and relevant regulatory provisions and updates.

Accountants who prepare financial statements must be familiar with both basic and diluted EPS. Basic EPS is a simple indicator of a firm’s financial health, while diluted EPS provides a more complex alternative. The latter is preferred by some investors, who see it as a superior measure since it shows how well a company could perform if all of its convertible securities were exercised.

If there’s a major difference between a company’s basic and diluted EPS, that can be a red flag. It indicates that a large amount of value is not available to investors since it is tied up in potential exercises of convertible securities.

Mastering EPS with an online MAc from UAB

The 100% online MAc program at UAB is your opportunity to become an expert accountant who can prepare accurate EPS calculations that keep investors informed. With a flexible structure and a comprehensive curriculum, the MAc covers advanced topics in financial accounting and provides deep preparation for exams such as the CPA examination. After graduating, you will be prepared to pursue positions such as financial analyst, financial manager, and CFO.

To learn more, visit the program overview page, where you can answer a few simple questions to receive further information.

Recommended Reading:

Career Spotlight: Chief Financial Officer What you can learn about income taxation

Sources:

What Is the Formula for Calculating Diluted Earnings Per Share?

The limitations of earnings per share

Earnings per share