Category: Finance

Diluted Earnings per share

Contents:

  1. Diluted EPS
  2. Calculation of Diluted EPS
    • Diluted EPS using if converted method
    • Diluted EPS using Treasury stock method
  3. Antidilutive security

Diluted EPS

Diluted EPS reflects the effect of all the company’s securities whose conversion / exercise would result in a dilution (reduction) of basic EPS.

Dilutive securities includes:

  1. convertible debt,
  2. convertible preferred shares,
  3. warrants,
  4. Options
  5. Employee stock options

Calculation of Diluted EPS

Diluted EPS =

(Net income available for common stockholders + Income adjustments due to dilutive financial instruments) / (Weighted average number of shares outstanding + Newly issuable shares due to dilutive financial instruments)

Diluted EPS on Convertible Preference shares using if converted method:

The conversion of preference shares has two effects on diluted EPS formula:

  1. Increase in denominator of outstanding shares on conversion of preference shares
  2. Increase in the numerator (Net income available for common stockholders) by dividends on convertible preferred stock.

Let’s understand this with the help of below example:

Net income$11,800
Ordinary shares 5,000 shares outstanding
Preferred shares ($2 dividend per share each year)
900 shares outstanding convertible into 2 ordinary shares
Total Preference dividends for the year $1,800
Basic EPS ($11,800 − $1,800) / 5,000 $2.00

Adjusted net income attributable to ordinary shareholders =

=11,800 + 1,800 ( Preference shares dividend no longer payable on conversion)

= $13,600

Number of shares outstanding on conversion of preference shares = 2000+ 1,800 = 3,800

Diluted EPS = 13,600 / 3,800 = $3.58 per share

Diluted EPS on Stock options using Treasury stock method

An option or warrant gives the holder the right to buy shares at some time in the future at a predetermined price.

Treasury-stock method assumes that proceeds received on exercise of the options is used to buy back shares at the average market price.

To calculate diluted EPS with an option, you need to work out the number of ‘free’ shares that will be issued if the options are exercised, and add that to the weighted average number of shares

Diluted EPS is calculated as if the financial instruments had been exercised and the company had used the proceeds from exercise to repurchase shares of common stock at the average market price of common stock during the period.

The weighted average number of shares outstanding for diluted EPS is thus increased by the number of shares that would be issued upon exercise net of the number of shares that would have been purchased with the proceeds.

We will understand this with the help of below example:

Net income$12,000
Ordinary shares shares outstanding2,000
Basic EPS ($12,000) / 2,000) $6
Stock options (200 options with exercise
price of $80), 200 shares to be issued on exercise
Average market price per ordinary share during
the year 		$100

Proceeds from exercise of options = 200 x $ 80 = $ 16,000

No. of shares purchased from proceeds of exercise =$ 16,000 / 100 (average market price) =160 shares

Total number of shares outstanding = 2000 + 200 – 160 = 2040 shares

Diluted EPS = 12,000/2,040 shares = $5.88

Antidilutive security

Antidilutive security is a potentially convertible securities whose inclusion in the computation results in an increase in EPS than the basic EPS or a reduction in loss per share.

Under IFRS and US GAAP, antidilutive securities are not included in the calculation of diluted EPS.

Summary

Diluted EPS is an important metric for investors to know how much will be the potential dilution in earning per share if all convertible securities were exercised.

Related articles:

What is Earning per share (EPS)

What is PE Ratio?

What is Earnings per share (EPS)?

Earnings per share (EPS) is the company’s net profit available to equity shareholders (common stockholders) divided by the number of outstanding common shares.

EPS is reported on the face of the income statement / profit & loss statement.

How EPS is calculated?

Earnings per share (EPS) (also known as Basic EPS) is calculated as under:

Basic EPS  =   (Net income – Preferred dividends) / Weighted average  number of shares outstanding

The weighted average number of shares outstanding is calculated by the length of time each quantity of shares was outstanding during the year.

Example: A company has reported following numbers on 31.12.20X1:

Particulars$
Net income (PAT)1,300,000
Preference shares 10%, 2,000,000 shares of $1 each2,000,000
Common stock outstanding on 01.01.20X1 400,000 of $1 each
Common stock issued on 01.07.20X1 400,000
Common stock repurchased on 01.10.20X1 200,000
Common stock outstanding on 31.12.20X1 600,000
EPS llustration

Step 1: Calculation of weighted average number of shares outstanding:

400,000 shares * 6/12200000
8,00,000 shares * 3/12 i.e. (400,000+400,000)2,00,000
6,00,000 shares * 3/12 i.e. (800,000-200,000)1,50,000
weighted average number of shares outstanding5,50,000

Step 2: Net profit available to equity shareholders = PAT – Preference shares dividend

= 1,300,000 – 200,000* = 1,100,000

Step 3: Basic EPS = 1,100,000 / 550,000 = $ 2

*10% of $ 2,000,000 Preference shares capital

Utility of EPS

  • A comparison of year on year EPS growth indicates that profit per share is increasing which is positive for investor and vice versa.
  • From investor perspective, EPS indicates how much profit is earned on each share.
  • EPS is used an input into the price/earnings ratio.

Related articles:

Diluted EPS

What is PE Ratio?

How Compound interest  works to grow wealth?

My wealth has come from a combination of living in America, some lucky genes, and compound interest“

– Warren Buffett

Compound interest means interest on interest. It is the result of reinvesting interest, rather than taking it out.

To understand the concept, let us assume $10,000 is invested @ 5% interest which is withdrawn at the end of each year. Total simple interest earned will be $ 1500 at the end of 3 years

YearPrincipalInterest @ 5% p.a.
110,000500
210,000500
310,000500
Total interest1500
Table 1: Simple interest

Let us assume $10,000 is invested @ 5% interest which is reinvested at the end of each year. This means at the end of year 1, interest earned $ 500 will be added to $ 10,000 principal and interest will be calculated for year 2 on $ 10,500 amounting to $ 525. Total cumulative interest earned will be $ 1576 at the end of 3 years

YearPrincipalInterest @ 5% p.a.
110,000500
210,500 (10000+500)525
311025 (10500+525)551
Total interest 1576
Table 2: Compound interest

We can see that compound interest results in interest of $1576 at the end of 3 years compared to simple interest of $ 1500, i.e. an extra interest of $ 76 by just keeping interest reinvested.

One can see, how power of compounding can help grow your wealth much faster.

What is PE Ratio?

What is PE ratio?

The Price-to-Earnings (PE) Ratio is a valuation metric used to determine the relative value of a company’s shares by comparing its share price to its earnings per share (EPS). It essentially reflects how much investors are willing to pay for each dollar of a company’s earnings.

PE ratio shows how many years it will take to recover the money invested in a company assuming it’s earnings remain constant.

Calculation of PE ratio

The formula for PE ratio is as under:

PE ratio = Price / Earning per Share (EPS)

For example, XYZ ltd. EPS is $ 5 and market price of the share is $ 50. The PE ratio in this case will be 10.

This means that investors are willing to pay 10 times the company’s earnings for each share. In other words, it would take 10 years of the company’s earnings to recover the investment in its shares, assuming constant earnings.

PE Ratio Interpretation

  • High PE Ratio: Often indicates high growth expectations, meaning the company might be perceived as having strong future prospects. However, it could also indicate that the stock is overvalued.
  • Low PE Ratio: Could indicate lower growth expectations or a riskier business model, which may cause investors to discount its value. Conversely, it might signal an undervalued stock.
Type of companiesPE Ratio
High growth companies Typically have a high PE ratio because investors expect future earnings to increase significantly.
High risk companiesOften have a low PE ratio because of the uncertainties or risks associated with their business.
Firms with high reinvestment needsMight also have lower PE ratios as a lot of their profits are reinvested back into the business rather than being reflected in current earnings.

Limitations

The PE ratio can be influenced by a company’s capital structure (debt vs. equity), which might distort its valuation.

It may not always provide a complete picture, especially when comparing companies with different levels of debt or capital investment needs.

For a more comprehensive assessment, other multiples like EV/EBITDA (Enterprise Value to Earnings Before Interest, Taxes, Depreciation, and Amortization) are often used, as they neutralize the effects of capital structure differences.

The PE ratio, while useful, should be considered alongside other financial metrics to get a full understanding of a company’s value.

Rule of 72

The rule of 72 is used as rule of thumb for estimating an investment’s doubling time.

The formula of Rule of 72 is

T  =  72/r

Where

r  = rate of interest / year

T = number of periods required to double an investment’s value

For example, we want to know what is the time required to double investment @ 6% rate of interest.

It will take 12 years ( T = 72 / 6) to double the interest.

So, next time someone asks you to tell how much time an investment at a certain rate of interest takes to double your money, use of Rule of 72 can be a quick handy tool and you do not need our calculator or laptop.

It may be noted that Rule of 72 & other variations i.e. the rule of 70 and the rule of 69.3 gives approximate time an investment takes to double the investment.