How Do Earnings Become Diluted?

Many companies report basic and diluted earnings per share, what dilutes earnings?

First, let’s take a look at the formula for earnings per share (EPS):

EPS = Net income/number of shares outstanding

Photo by Biology Big Brother, courtesy of flickr

From the formula, we can see that EPS is inversely related to the number of shares a company has outstanding.

So, earnings become diluted when the number of shares outstanding increases. Now let’s look at some items which can impact the number of outstanding shares.

Employee Stock Options (ESOs) – Options are contracts that give their holders the right to buy or sell shares. ESOs are call options issued by a company to its employees.

Convertible securities – Sometimes companies issue convertible bonds or shares of preferred stock. After a certain period, both securities can be converted to shares of common stock.

Warrants – Warrants are similar to options, but they are issued by the company. They allow their holders to buy (or in a few cases, sell) shares of stock later on. Warrants are often issued in M&A activity, and are referred to as deal sweeteners.

Why does the number of shares matter? The number of outstanding shares matters because several investors use per share figures for valuation purposes. Earnings per share, cash flow per share and sales per share are often used in conjunction with growth prospects in order to arrive at the expected stock price.

Here’s a sample formula for valuation: Expected stock price = historical P/E ratio x projected EPS

The historical ratio may be the average P/E ratio over a period of several years (five is typical) and the projected EPS figure is the EPS expected for the next year.

If EPS falls, then the expected stock price will fall. So, a huge gap between basic and diluted earnings could be sign that the value of the shares will become diluted.

The diluted EPS figure gives you the worst case scenario in which all convertible securities have been converted and all options have been exercised. It may never actually happen, at least not all at once, but it is definitely good to know.

To find both basic and diluted EPS, just look at the bottom of the company’s income statement.