Basic and Dilutive Earnings Per Share (EPS)
Basic EPS tells how much of the earning you can share if you own 1 share of common stock. By definition,
Basic EPS = (net income -
preferred dividend)/ total number of common stock
However, there may be warrants, options, convertible debts and convertible preferred stocks outstanding, what if all the holders try to convert their holdings to common stock and "share" the earnings with other common stock holders? Then we have to add the preferred dividend and debt interest back to the numerator and change the effective number of common stocks. Therefore,
Dilutive EPS = (net income – debt interest (1-tax rate)) / effective number of stocks
Traps and Tips:
- Make sure the conversion is dilutive! i.e. the dilutive EPS is less than the basic EPS. Every time, when you see such questions, it is better to calculate basic EPS before committing to the dilutive EPS calculation!
- There are 2 types of preferred stocks: Convertible and non-convertible! Keep non-convertible as it is as in calculating Basic EPS. Don’t touch it!
- A quick way to check if it is dilutive, compare the following ratio with the basic EPS calculated: (Income to be adjusted) / (Share number to be added)
|
|
Income to be adjusted |
Adjusted Share Number |
|
Conv. Preferred Stock |
Conv. Preferred Stock Dividend |
Share Convertible |
|
Conv. Debt |
Debt interest x (1-t) |
Share Convertible |
|
Warrant / Stock Options |
No adjustment |
Share Convertible * (1- average price/exercise price) |
I just encountered this question! It’s tough! See if anyone can get it in 1.5mins!
A company has earning of $200k and outstanding share of 100k. It also has 500 convertible preferred stock (10% with $2k par) equivalent to 50k common stock. What is the dilutive earnings per share?
(Ans: $1 per share)
Let me know if you need explanation!
Hi superman !!
Can you clarify the answer please ??
The dividend to preferred stocks holders = 10% x 2k x 500 = 100k => earnings attributable to common stock holders = $200k – 100k = $100k
So the basic EPS = $100k/100k = $1/share
If preferred stock holders exercise the right (convert to common stock), without paying dividend to preferred stock holders, the earnings attributable for common stock holders is still $200k. However, after conversion, the new # of common stocks outstanding is 100k + 50k. =150k. So the new EPS is $200/150 = 1.33/share which is > $1/share. So this is antidilutive!
So the dilutive EPS is still $1/share.
hi just got a question about the warrant. I’m doing the past exam paper from Schweser. sample paper 1 afternoon section. question 52 asked about the number of share outstanding on the following information. what happen is that they calculate the warrant by 1-strike price/average price. which is different with what u got on. so i’m abit confuse now, if u see this can u explain abit more. cheers :)
I dont think I can solve that even in 5 mins.