Earnings per share (EPS) is a crucial metric for investors, showing how much profit a company makes per outstanding share. This section breaks down the calculation of basic EPS and introduces the concept of diluted EPS, which accounts for potential share increases.

Dilutive securities, like stock options and convertible bonds, can lower EPS by increasing the number of shares. We'll explore how to calculate their impact using methods like the treasury stock and if-converted approaches, and see how they affect diluted EPS calculations.

Basic Earnings Per Share

Calculation and Components

• Basic earnings per share (EPS) measures a company's net income available to common shareholders divided by the weighted average number of common shares outstanding during a period
• Formula for basic EPS: $\text{Basic EPS} = \frac{\text{Net Income - Preferred Dividends}}{\text{Weighted Average Number of Common Shares Outstanding}}$
• Net income adjusts for preferred dividends and other items affecting income available to common shareholders (discontinued operations, extraordinary items, changes in accounting principles)
• Weighted average shares outstanding accounts for changes in share numbers during the reporting period, considering timing and impact of stock issuances or repurchases
• Weighted average shares calculation prorates the number of shares outstanding for the portion of the reporting period they were outstanding

Reporting and Significance

• Basic EPS disclosure required on the face of the income statement for public companies by accounting standards
• Provides investors with a fundamental measure of a company's profitability on a per-share basis
• Serves as a starting point for more complex EPS calculations and analysis
• Allows for comparison of profitability across different companies and time periods

Dilutive Securities Impact

Types and Characteristics

• Dilutive securities decrease earnings per share by increasing the number of common shares outstanding if converted or exercised
• Common types include convertible preferred stock, convertible bonds, stock options, and warrants
• Dilutive effect occurs when conversion or exercise price is lower than current market price of common stock
• Anti-dilutive securities increase EPS if converted or exercised and are excluded from diluted EPS calculations

Calculation Methods

• Treasury stock method used for stock options and warrants
  • Assumes proceeds from exercise are used to repurchase shares
  • Example: Company has 100,000 stock options with exercise price of $20, current stock price is $25
    • Potential shares: 100,000 x ($25 - $20) / $25 = 20,000 shares
• If-converted method applied to convertible securities
  • Assumes conversion at the beginning of the period or date of issuance, whichever is later
  • Example: 1,000 convertible bonds, each convertible to 50 shares
    • Potential shares: 1,000 x 50 = 50,000 shares
• Incremental EPS approach assesses impact of each dilutive security to determine inclusion in diluted EPS

Diluted Earnings Per Share

Calculation Process

• Diluted EPS reflects potential reduction in EPS if all dilutive securities were converted or exercised into common stock
• Formula: $\text{Diluted EPS} = \frac{\text{Adjusted Net Income}}{\text{Weighted Average Common Shares + Potential Common Shares}}$
• Adjusted net income includes adjustments for:
  • Interest expense (net of tax) on convertible debt that would no longer be paid upon conversion
  • Preferred dividends on convertible preferred stock that would no longer be paid upon conversion
• Potential common shares added to denominator based on treasury stock and if-converted methods
• Step-by-step calculation process starts with most dilutive securities, progressing to least dilutive

Complex Scenarios

• Complex capital structures with multiple types of potentially dilutive securities require careful sequencing in diluted EPS calculation
• Anti-dilution sequencing rule may require recalculation if including a security becomes anti-dilutive when combined with others
• Example: Company has convertible bonds and stock options
  • Calculate dilution from bonds first, then add dilution from options
  • If combined effect becomes anti-dilutive, recalculate excluding the least dilutive security

Basic vs Diluted EPS Significance

Interpretation and Analysis

• Difference between basic and diluted EPS indicates potential dilution from convertible securities and stock options
• Large gap suggests higher degree of potential dilution and significant outstanding convertible securities or stock options
• Investors often focus on diluted EPS for a more conservative view of earnings potential
• Trends in basic vs diluted EPS relationship over time reveal changes in capital structure or employee stock option exercises
• Example: Company A has basic EPS of $2.00 and diluted EPS of $1.80
  • Indicates 10% potential dilution if all convertible securities and options are exercised

Reporting and Investor Considerations

• SEC requires companies to reconcile basic and diluted EPS, explaining dilution sources in financial statement footnotes
• Analysts use basic vs diluted EPS comparison to assess:
  • Earnings quality
  • Potential impact of future share issuances on shareholder value
• Narrowing gap between basic and diluted EPS over time may indicate:
  • Conversion of dilutive securities
  • Company share buybacks
  • Potential signal of management's confidence in stock value