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 (usually just referred to as "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 2 Different Earnings Per Share Calculations Are Useful
When you dive into the profit and loss statement of a company, you have to do it on two levels.
- First, look at the entire business. How profitable is the company as a whole?
- Second, examine the profits per share. Publicly traded companies are cut up into individual pieces, or shares, and each of those shares represents part of the overall ownership pie. How much of the after-tax income is each piece of the company entitled to receive?
For the individual investor, the second figure is what counts. If a company generates more profit each year, but 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 to shareholders. It could be a terrible investment.
Profits get lost on their way to shareholders—or "diluted"—for a variety of reasons. A merger or acquisition may result in new shares being issued, or employees may have stock options with vesting periods that are ending, or there may be dilutive securities such as warrants or convertible preferred stock. Investors encounter these circumstances more often than you might expect, but 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 shareholders are, in effect, giving up some of their ownership to whoever is receiving the new share.
Fortunately, the accountants who develop the "generally accepted accounting principles" (GAAP) 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 EPS figures in their disclosures: basic earnings per share and diluted earnings per share.
Calculating Basic Earnings Per Share
Basic EPS is a straightforward 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, let's say a business had $100 million in net income applicable to common shares for its most recent fiscal year. It started that year with 20 million shares outstanding and ended that year with 15 million shares outstanding. The basic EPS calculation would be:
$100 million net income applicable to common shares ÷ ([20 million shares at the start of the year + 15 million shares at the end of the year] ÷ 2)
$100 million net applicable income ÷ 17.5 million average shares outstanding
This gives us a basic EPS of $5.71.
Calculating Diluted Earnings Per Share
Diluted earnings per share adjust the basic EPS 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.
Let's stick with our example from the basic EPS, but let's add in a new detail: an early investor holds a convertible security that, when the investor wants to convert it, could result in 5 million more shares being issued. That's in addition to the average outstanding shares of 17.5 million from the basic EPS example. The diluted EPS equation would then be:
$100 million net income applicable to common shares ÷ (([20 million shares at the start of the year + 15 million shares at the end of the year] ÷ 2) + 5 million shares in convertible options)
$100 million net applicable income ÷ (17.5 million average shares outstanding + 5 million shares in convertible options)
$100 million net applicable income ÷ 22.5 million shares
That gives us a diluted EPS of $4.44.
Some Quirks to Diluted Earnings Per Share
One thing to keep in mind about diluted EPS is the fact that anti-dilutive conversions are not included in the calculation. Doing so would increase earnings per share, but this isn't likely to happen in the real world. For example, an employee with a vested option to buy stock at $1 per share won't exercise that option when the stock is trading at $0.75 per share. Underwater stock options aren't included in the diluted EPS calculation, only stock options that are eligible for conversion and have a strike price below the current market price.
If a company has a lot of potential dilution on its books, and the stock price suddenly declines for whatever reason (a company-specific situation, a broad economic recession, etc.), all of that dilution could disappear from the diluted EPS calculation. If you don't account for the fact that higher stock levels in the future will reintroduce all of that dilution, your projected earnings could be far off the mark. If the stock price remains depressed for a long time, some stock options will expire, but that's usually cold comfort—management is likely to issue itself new stock options at a 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. 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 essentially taking away more than $390 million in value from the investors. 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.
|IntelExcerpt: 2001 Annual Report|
|Earnings per share from continuing operations||2001||2000|