Tuesday, 25 September 2012

Diluted EPS

Basic EPS  :
The Basic EPS is the EPS which accrues to the shareholders of the company. This is derived by dividing the net profit (after deducting dividend on preference shares) of a company by the total number of shares outstanding.

Diluted EPS:
Diluted EPS is derived by dividing the total earnings by the number of shares that would be outstanding if the holders of equity warrants, convertible bonds, convertible preferred shares and stock options, exercise their options to obtain common shares. It is known as diluted EPS because of the proportional reduction in the ownership interest because of the issuance of new common shares.

For example, if the holder of convertible bond exercises his options to obtain common shares, than it will affect both the numerator and denominator of the EPS formula.

EPS = Total earnings / Weighted average number of outstanding shares

So when the holder exercise the option, the company is now not liable to pay interest to the holder, which will increase the total earnings (numerator) and the company will issue number of common shares to bond holders, which will increase the denominator. But the investor does have to calculate basic or diluted EPS. The companies report these figures along with the details of EPS computation in the footnotes of financial statements.

A big difference in basic and diluted EPS can indicate the presence of high potential of dilutive  securities. The diluted EPS is lesser than the basic EPS since the number of share increases while calculating diluted EPS. 

Due to this, the trailing P/E calculated on the basis of diluted EPS is higher than the trailing P/E calculated on the basis of basic EPS and the stock looks overvalued or expensive. But investors should prefer to use diluted EPS for calculating trailing P/E ratio as it makes the comparison among companies with difference amount of dilutive securities easier and relevant.

Second major benefit of using diluted EPS is that it shows the worst case scenario. If dilutive securities holder exercise their option due to any reason, than the common investor will be on safe side. Third reason why an investor should use diluted EPS is because major well known experts, research analyst and brokers use diluted EPS for calculating trailing P/E.


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