Basic Earnings per Share vs. Diluted Earnings
How to Analyze an Income Statement
When analyzing an income statement it's important to know the difference between basic earnings per share (basic EPS) and diluted earnings per share (diluted EPS). This is a particularly important area for stock investors because, if you aren't careful, you can end up using the wrong EPS figure and thus end up with a misleading price-to-earnings ratio, PEG ratio, and dividend-adjusted PEG ratio.
Why Have Two Different Earnings per Share Numbers?
When you dive into the profit and loss statement of a company, you have to do it on two levels.
- The first is looking at the entire business. Namely, how profitable is the company as a whole?
- The second is examining the profits per share. Publicly traded companies are cut up into individual pieces, with each of those pieces representing part of the overall ownership pie. How much of the after-tax income is each individual piece of the company entitled to receive?
For the individual investor, the second figure is what really counts. If a company generates more and more profit each year, but very little of that additional profit makes its way to the shareholders on a per-share basis, the prosperity of the business doesn't mean much, as it could still be a terrible investment. This could happen for a variety of reasons—such as new share issuances for mergers and acquisitions, stock options given to executives, or dilutive securities such as warrants or convertible preferred stock. This is a fairly common problem and one you'll likely discover more often than not.
Truly shareholder-friendly management teams focus on the per-share results, prioritizing them over the size of the company. Such management understands that each time a new share is issued, the existing owners are, in effect, selling some of their current business assets and giving them up to whoever is receiving that share.
Fortunately, the accountants who develop the GAAP rules for financial statements found in the annual report and 10-K filing came up with a solution. It's not perfect, and it won't catch everything, but it's a great place to start. They decided to require companies to present two different earnings per share figures in their disclosures.
Calculating Basic EPS and Diluted EPS
The two figures required by GAAP are basic EPS and diluted EPS.
- The first figure is known as basic EPS. Basic earnings per share is a straightforward, simple calculation that attempts to take the net income applicable to common shares for a period and divide it by the average number of shares outstanding for that same period. For example, if a business had $100,000,000 in net income applicable to common shares for its most recent fiscal year, and it started that year with 20,000,000 shares outstanding and ended that year with 15,000,000 shares outstanding, the basic EPS calculation would be $100,000,000 ÷ ([20,000,000 + 15,000,000] ÷ 2), or $5.71.
- The second figure is known as diluted EPS. Diluted earnings per share adjusts the basic earnings per share figure by including all potential dilution that, if triggered at present prices and conditions, would result in the reported earnings per share being lower than they otherwise would have been. For example, using our earlier illustration, if there were 5,000,000 shares of stock that could be issued at any time due to a convertible security held by an early investor being eligible for conversion at a price lower than the current market price, the formula would need to account for that. Diluted EPS would be $100,000,000 ÷ ([[20,000,000 + 15,000,000] + 5,000,000] ÷ 2), or $4.44.
Some Thoughts on Using Diluted EPS When Analyzing a Business
One thing to keep in mind about diluted EPS is the fact that antidilutive conversions are not included in the calculation. Doing so would increase earnings per share, which isn't likely to happen in the real world. (What sane person would exercise an underwater option or convertible security at a price that causes them to pay more than they could get if they went to the open market and bought shares?) This means, for example, that underwater stock options aren't included in the diluted EPS calculation, but stock options that are eligible for conversion and have a strike price below the current market price are.
From a practical standpoint, when you understand these calculations, the implications become clear: If a company has a lot of potential dilution on its books, and the stock price then declines either due to a company-specific situation, a recession, or a broad stock market collapse, all of that dilution could disappear from the diluted EPS calculation.
If you don't account for the fact that higher future stock levels will suddenly reintroduce all of that dilution, your projected earnings could be far off the mark. To some extent, at least as far as stock options go, if the stock price remains depressed for a long period of time, some stock options will expire, but that's usually cold comfort as management is likely to issue itself new stock options at the lower price.
A general rule of thumb to remember is that diluted EPS will always be lower than basic EPS if the company generated a profit, because that profit has to be divided among more shares. Likewise, if a company suffers a loss, diluted EPS will always show a lower loss than basic EPS because the loss is spread out over more shares.
Looking at Intel As an Example
The figures below are from Intel, a technology company, in the aftermath of the dot-com boom, which demonstrated all of this quite well. Looking at the chart below, notice that in 2000, the difference between Intel's basic EPS and diluted EPS amounted to around $0.06. If you consider that the company had over 6.5 billion shares outstanding, you realize that dilution was taking more than $390 million in value from the investors and giving it to management and employees. That was a huge amount of money. Later, in 2001, as the markets continued to collapse, a lot of the stock options went underwater, and thus the dilution effect evaporated temporarily in the calculation of diluted EPS.
Excerpt: 2001 Annual Report
|Earnings per share from continuing operations||2001||2000|