Diluted Earnings Per Share

The primary earnings per share (basic EPS) test is not always the most accurate way to measure. Stock options, if on the books in considerable numbers, will drastically affect the dilution of earnings, and also should be considered when going through the calculation. (Dilution is the reduction in book value per share of stock that occurs when new shares are sold or options exercised.)

To ensure that comparisons are accurate, you need to be aware of the effects of dilution and how it might affect the earnings per share calculation. To understand how dilution works, review the basic attributes of convertible securities. The process of conversion involves exchanging one form of investment for another. This would occur at a point that shares of common stock are equal to or surpass the value of the currently owned security. When the two securities are of equal value, they are at parity.

The first form of convertible security includes some forms of preferred stock. This is a class of stock generally less risky than common stock because shareholders have priority for payment of dividends and for liquidation in cases of bankruptcy. Preferred shareholders do not have voting rights, as common shareholders do. Some forms of preferred stock may be classified as convertible preferred stock. This means the shareholders may exercise the right to convert preferred stock to common stock by a specified deadline and/or at a predetermined price per share. This option to convert would make sense if and when the market price of a share of common stock reached or exceeded parity.

The second form of convertible security is the convertible bond. This feature often is added to bonds as a means for marketing them to investors. The right to convert to common stock would become attractive if the market value of stock exceeded that level, or if the interest rate being earned on the bond turned out to be low compared to prevailing market rates.

With the types of convertible securities in mind, the concept of dilution—and the effect it might have on the calculation of earnings per share—is more easily appreciated. When a company carries convertible preferred stock or bonds on its books, that does not mean that conversion will occur. Of course, if the stock's market price were to reach and/or exceed parity, then conversion is virtually certain. If you are comparing the earnings of such a company with those of another company that does not carry any convertible securities, then the comparison is not really the same. The effects of dilution in the event of conversion have to be taken into account. Bonds and preferred stock converted to common stock reduce the earnings per share.

Thus, a new calculation is required to account for the contingent effect of conversion. If conversion were to occur, earnings per share would be diluted; the greater the dollar amount of convertible securities and the higher the number of common shares involved, the greater the effect of dilution will be. The calculation of diluted earnings per share involves two modifications to the more common primary earnings per share. First, the net profit is increased by the conversion value of all convertible preferred stock and convertible bonds. Second, the outstanding shares of common stock are increased to reflect the new number of such shares that would exist after conversion.

The formula for diluted earnings per share is shown in Figure 6.3.

The important point to remember about using diluted versus basic earnings per share is that so doing makes the comparison accurate and consistent when comparing earnings per share for two or more corporations when not all of them offer convertible securities. If you are watching a trend in one company only, or if you are comparing two corporate earnings per share where neither have convertible securities, then dilution is not an issue.

KEY POINT

Tracking earnings per share in two dissimilar companies will not be accurate if convertible securities are on the books in either of the companies. Calculate diluted earnings per share to solve this problem.

FIGURE 6.3