Earnings per share measures the amount of income a company generates per share of stock outstanding. In general, the higher the EPS, the more valuable the stock. However, investors make two different EPS calculations: basic EPS and diluted EPS. Basic EPS measures the earnings per share currently outstanding. Diluted EPS takes a worst-case scenario approach and figures the earnings per share if everyone who could convert other shares or debt to common shares did so. For example, suppose a company pays its executives with stock options. When those executives exercise the options, the company's outstanding shares will increase.
Subtract the dividends paid to preferred shareholders from the company's net income to find the net income available to common shareholders. For example, if the company has $5 million in net income but pays $500,000 in preferred dividends, the company has $4.5 million in income available to common shareholders.
Calculate the weighted average number of common shares outstanding by multiplying the number of shares outstanding by the fraction of the year the shares were outstanding and adding the results. For example, assume that for the first nine months of the year, the company had 500,000 shares outstanding and for the last three months, the company had 600,000 shares outstanding. This means that the company had 500,000 for 75 percent of the year and 600,000 shares for 25 percent of the year. The weighted average of shares outstanding equals 500,000 times 0.75 plus 600,000 times 0.25, or 525,000 shares outstanding.
Divide the income available to common shareholders by the weighted average number of common shares outstanding to calculate the basic EPS. In this example, divide $4.5 million by 525,000 shares to get an EPS of about $8.57.
Add the number of potential shares that could be created by conversion of preferred shares or exercising stock rights to the weighted average number of common shares outstanding. For example, assume you have a weighted average of 525,000 common shares outstanding. Also assume that 100,000 preferred shares could be converted to 20,000 common shares; that employees have 10,000 shares of stock options; and that convertible bonds could be redeemed for 30,000 common shares. Add 525,000 to 20,000 to 10,000 to 30,000 to find the total number of potential shares equals 585,000.
Add back the preferred dividends paid on any preferred shares that could be converted to the income available to shareholders. In this example, if the preferred shares that could be converted received $100,000 in dividends and the net income available to common shareholders is $4.5 million, add $100,000 to $4.5 million to get $4.6 million.
Add back the after-tax interest expense paid on any convertible bonds. In this example, if the convertible bonds were paid $100,000 in interest, add $100,000 to $4.6 million to get $4.7 million.
Divide the income available to common shareholders by the new weighted average of shares outstanding to figure the diluted EPS. Finishing the example, divide $4.7 million by 585,000 to find the diluted EPS equals about $8.03.
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