Basic earnings per share (EPS) and diluted EPS are used to measure the profitability of a company. Basic EPS is calculated, taking into account the outstanding equity shares of the company. Diluted EPS includes convertible shares such as employee stock options, warrants, debt in its calculation. For an investor, basic EPS vs diluted EPS becomes an important debate as both are essential for the fundamental analysis of a company.
Basic EPS vs Diluted EPS calculation:
EPS can be calculated with the given formula:
Basic EPS = (Net income – Preferred dividend) / Outstanding common shares
For example, if a company earned a net profit of Rs 50 crore and the total outstanding shares were 1 crore, then the EPS would be Rs 50 per share. However, this formula poses a problem. Basic EPS takes into account only outstanding shares. A company may have other potential sources of dilution of equity. For instance, a company may have issued warrants which, when exercised, will lead to dilution of equity. Alternatively, the company may have issued convertible debentures which if converted, could also increase the number of outstanding shares. All such potential sources of equity dilution are taken into account while calculating diluted EPS. Thus, diluted EPS gives a clear picture of a company’s actual earnings per share.
Earlier, it was not essential for companies to declare diluted EPS. However, now we can see the diluted EPS in every financial statement of the company.
Diluted EPS is calculated with the formula:
Diluted EPS = (Net income + convertible preferred dividend + debt interest) / All convertible securities plus common shares
To calculate diluted EPS, it is necessary to identify all potential shares, such as any financial instrument that can result in more shares in the future. Potential ordinary shares include the following:
1. Stock options and warrants
3. Convertible preferred shares
Stock options are employee benefits that allow the buyer to purchase common shares at a predetermined time and price. Convertible preferred shares and convertible bonds are similar and can be converted into common shares at the time and rate mentioned in their contract.
Basic EPS vs diluted EPS application:
EPS is important in calculating the P/E ratio, which is used for the valuation of the company. Hence, the precise calculation of EPS is important.
Diluted EPS is more scientific than basic EPS.
For fundamental analysis, diluted EPS is more effective as it includes the impact of all potential equity diluters. This ensures the company’s EPS is in line with future expansion. Hence, this is more important for the P/E calculation.
Basic EPS serves the purpose on most occasions except when there is significant dilution in a company. Then diluted EPS makes more sense.
Basic EPS vs diluted EPS differences:
Some of the key differences between basic EPS and diluted EPS are:
1. Although very suitable, basic EPS is not a good measure of the company’s financial health. Diluted EPS is a stricter approach to know how a company is doing financially
2. Basic EPS is a simple measure as compared to diluted EPS
3. Basic EPS is used for companies with a simple capital structure, while diluted EPS is used for companies with more complex capital structures. Most large companies have potential diluters, and hence for them, diluted EPS is more meaningful
4. Diluted EPS is always lower than basic EPS as all convertible shares are added to the common shares in the denominator for diluted EPS
5. Basic EPS does not consider the effect of equity dilution on profit, while diluted EPS does
Basic EPS vs diluted EPS comparative table:
|Basic EPS||Diluted EPS|
|Basic earnings of the company per equity share||Revenues of the company per convertible share|
|It is less significant to investors as it does not include convertible shares||More significant to investors|
|Helps to evaluate the profitability of a company||Helps to assess profitability with convertible securities|
|Common share included in the calculation||Common shares, stock options, preferred shares, warrants, debt all included in the calculation|
|Easy to use||Comparatively more complex|
Ascertaining both basic EPS and diluted EPS helps to see the financial health of the company more accurately. It is always better to compute both if the company’s capital structure is complex.