Understanding Diluted Shares Outstanding and Their Impact on Earnings Per Share
A company can post good profits, but the investors want to find out how much of the company's profit goes to each investor. This is one of the reasons why earnings per share (EPS) is a key financial indicator to closely watch. But the number of shares a company has at the moment, doesn't necessarily mean it will have in the future.
Others can provide stock options, convertible bonds or any other security that can result in more shares being issued. If these potential shares are taken into account, then the earnings per share will be reduced. This is where the diluted shares outstanding and diluted EPS come into play since they give a more conservative estimate of the earnings of the shareholders.
Diluted Shares Outstanding
Diluted shares outstanding are the number of shares which would be outstanding in the event that all convertible securities were exercised and converted into ordinary shares.
These potential shares could be through employee stock options, convertible preferred shares, warrants or convertible debt. Even though these securities might not have been converted, accounting rules require companies to factored in the potential conversion when they are determining the diluted EPS.
This allows the investor to have a view on how his/her holdings and returns may be impacted in the future by share dilution.
Earnings Per Share (EPS)
EPS is a measure of the profit that is generated for every ordinary share held by the shareholders during the reporting period.
EPS is used to analyse profitability and make comparisons between companies in the same sector as it relates the profit of the company to the number of shares held by the investors. An increaseEPS will likely indicate that the company is making more profit for every share issued, but should be examined in conjunction with other financial metrics.
Investors keep an eye on the changes in EPS over a number of years to assess the performance of the business over the long term.
Diluted Earnings Per Share
Diluted earnings per share is the same as EPS except that all securities that can be converted to ordinary shares are assumed to be converted.
This makes diluted EPS typically equal to or lower than basic EPS, as it is based on the same earnings, but split into more shares. This calculation is a more conservative estimate of the earnings for investors should there be future dilution of shares.
Diluted EPS may be a more realistic measure of shareholder value for companies having a substantial number of convertible securities.
Basic vs Diluted EPS
In Basic EPS, only the weighted average of the common shares that are in existence during a reporting period are used.
Diluted EPS, on the other hand, accounts for all shares in the company, as well as the number of shares that can be converted into common stock from financial instruments that are eligible. This greater dilution can lead to lower EPS, due to diluted earnings per share.
EPS Formula
The formula for working out basic earnings per share is:
Net Income − Preferred Dividends = Shown on the bottom line of the income statement.Weighted Average Ordinary Shares Outstanding = Weighted Average Number of Shares Outstanding.
This will determine how much profit is reserved for every ordinary share, once preferred shareholders have been paid their shares.
The formula is simple but there are important concepts of financial information and the proper weighted average number of shares outstanding for the period that must be relied upon to make accurate calculations.
Diluted Shares Calculation
The steps are as follows to calculate diluted shares: first step is to calculate weighted average number of ordinary shares outstanding.
The accountants then check to see which of the convertible securities may be dilutive and estimate the number of additional shares that would be issued if the convertible securities were exercised or converted. The potential common shares are used in the calculation of diluted earnings per share and are included in the number of shares in the denominator.For calculating diluted earnings per share, these potential common shares are added to the denominator of the earnings per share calculation.
This can assist investors in assessing the potential impact of any future share issuance on the percentage of ownership and earnings of the investor.
Conclusion
Diluted shares outstanding and diluted earnings per share give investors a more complete picture of a company's earnings and financial situation, and include expected future share dilution. Basic EPS will show earnings based on the number of actual shares outstanding, whereas diluted EPS will show a more conservative figure that will adjust for convertible securities that may increase the number of shares. Both calculations can be reviewed to get a better perspective of profitability, and to assist better informed investment decisions.
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