EPS is one of the most commonly used corporate profitability performance measures for publicly traded firms. A company may have either a simple or complex capital structure. A simple capital structure is one that contains no potentially dilutive securities. A simple capital structure contains only common stock, nonconvertible debt, and preferred stock. On the other hand, a complex capital structure contains potentially dilutive securities such as options, warrants, or convertible securities.
All firms with complex capital structures must report both basic and diluted EPS. Firms with simple capital structures report only basic EPS.
The basic EPS calculation does not consider the effects of any dilutive securities in the computation of EPS.
- Basic EPS = (Net Income - Preferred Dividends) / weighted average number of common shares outstanding.
Before computing the dilutive EPS, you need to understand the following terms:
- Dilutive securities are stock options, warrants, convertible debt, or convertible preferred stock that would decrease EPS if exercised or converted to common stock.
- Antidilutive securities are securities that would increase EPS if exercised or converted to common stock.
The numerator of the basic EPS equation contains income available to common shareholders (net income less preferred dividends). In the case of dilutive EPS , if there are dilutive securities (e.g., convertible preferred stock, convertible bonds, or warrants) that will cause the weighted average common shares to change, then the numerator must be adjusted for the following:
- If convertible preferred stock is dilutive (meaning EPS will fall if stock is converted), the convertible preferred dividends must be added back to the previously calculated income from continuing operations less preferred dividends.
- If convertible bonds are dilutive, then the bonds' after-tax interest expense would not be considered as an interest expense for diluted EPS. Hence, interest expense multiplied by (1-tax rate) must be added back to the numerator.
The diluted EPS equation (assuming convertible securities are dilutive) is:
- diluted EPS = adjusted income available for common shares/weighted-average common and potential common shares outstanding
where adjusted income available for common shares is:
- Net income - preferred dividends + Dividends on convertible preferred stock + After-tax interest on convertible debt
Remember, each potentially dilutive security must be examined separately to determine if it is actually dilutive (would reduce EPS if converted to common stock). The effect of conversion to common is only included in the calculation of diluted EPS for a given security if it is in fact dilutive.
At the end of the day, we just used these figures taken for granted. With the understanding of how the computation is done, it will give you more insight into a company capital structure. Hence for a complex capital structure company, the dilutive EPS will give a better estimation of the earning per share. Cheers.