What are Diluted Earnings per Share?

Diluted earnings per share is a measure of profit. The formula for diluted earnings per share is:

Fully Diluted Earnings Per Share = (Net Income - Preferred Stock Dividends) / (Common Shares Outstanding + Unexercised Employee Stock Options + Convertible Preferred Shares + Convertible Debt + Warrants)

How Do Diluted Earnings per Share Work?

Let's assume Company XYZ had $10,000,000 of net income this year. If Company XYZ has 10 million shares outstanding, its basic earnings per share (EPS) is simply $1.00 ($10,000,000 / 10,000,000 shares).

However, this doesn't always give the full picture of Company XYZ's performance. When Company XYZ calculates its earnings per share, it will probably show two numbers: basic EPS and fully diluted EPS. If there are other Company XYZ securities that could become Company XYZ shares (that is, they are convertible into shares), diluted EPS will reflect what could occur if its earnings were spread over all of the securities that are or could be converted into Company XYZ common stock.

Unless a company has no other potential shares outstanding, diluted EPS is almost always lower than basic EPS. It is important to note, however, that only the securities that are 'in the money' (that is, there is a reasonable chance that they will indeed convert into common shares) are included in the diluted EPS calculation. This in turn means that diluted EPS can change when the company's share price changes (because the chance of conversion often rises and falls with the stock price).

Financial Accounting Standards Board Statement 128 sets forth the requirements for calculation and disclosure of diluted earnings per share on the income statement. SEC regulation S-X also sets forth the circumstances under which diluted earnings per share is disclosed.

Why Do Diluted Earnings per Share Matter?

Diluted EPS offers a clearer picture of the true shareholder base over which a company's earnings are spread. It is a classic, conservative 'what-if' calculation, and for this reason many analysts prefer the measure to basic EPS. Diluted EPS affects a company's P/E ratio and other valuation measures, which is why shareholders generally dislike it when companies issue potentially dilutive securities.

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Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

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