Take a look at any income statement, and you’ll see EPS (or earnings per share) divided into two categories: diluted EPS and basic EPS. Which EPS figure should you rely on, and what does those terms mean? Take a seat, grasshopper, and I’ll show you.
EPS is a standard metric for measuring how profitable a company is. While total net earnings indicate how much profit a company is bringing in, the direct effect on an individual shareholder is less clear. That’s where EPS, and consequently dilution, come in.
Basically, dilution refers to how many shares outstanding a company has. A company might have really high net earnings and a great P/E, P/B, and other such valuations… but if the company is too heavily diluted, then the “spoils” of war are reduced for shareholders. Too much dilution leads to a lower EPS, which in turn translates into a lower dividend payout.
As those who have been reading me for some time know, dividends are an extremely important aspect of my investing philosophy. Share appreciation is nice, but I’d prefer a steadily growing dividend payment that is consistent and reliable.
Remember that the total shares outstanding helps determine a company’s market capitalization, which in turn affects valuations and investing metrics.
The reason that earnings gets converted into EPS is so that investors focusing on the share price calculations can make comparisons. For example, a share price of $80.00 tells us nothing about P/E unless we also know that the EPS is $4.00. Of course, the same P/E calculation can be made with market capitalization divided by net earnings, but in both cases the metrics are multiplied by shares outstanding.
Share price * shares outstanding = market capitalization, and EPS * shares outstanding = net earnings. In effect we are making the same calculations, but notice that you can’t divide market cap by EPS, or share price by net earnings. It’s like trying to divide 6 inches by 4 cm.
My point is that problems with dilution aren’t apparent in other calculations, because the metrics are different, and so it’s something that can be easily overlooked.
Shares Outstanding Manipulation
You need to understand the physics behind shares outstanding to avoid confusion when I explain basic EPS and diluted EPS. Now, a company’s market capitalization is mostly unable to be changed.
A company can issue more shares or buy back stock, the first one dilutes EPS and increases shares outstanding, while the latter decreases shares outstanding, but in this process the market capitalization stays constant. What happens in these situations is that shareholders are either benefited or negatively affected.
Take the example of a company buying back stock. Like I said, this decreases shares outstanding, so you might originally think that market capitalization decreases along with it. This would be true, except that the share price automatically increases as much as the shares outstanding decreases, to keep the market cap steady.
Because the company is buying shares, this pushes the share price up. Investors are getting a “free” bump: share price rises, shares outstanding falls, causing EPS to rise… but there is a cost, the company pays for it out of their cash. The butterfly effect can be created here, as management confidence, a rising EPS and rising share price can attract additional investors.
I could really go into detail about the analysis behind share buybacks but that’s not the point of this article. Instead, notice the fine balance around shares outstanding. As a company manipulates their number of shares outstanding, other values change as a result.
Take the example where a company issues more shares, or dilutes their stock. Instead of buying shares the company is selling them, which creates cash for the company to use elsewhere but hurts current investors who’ll see share price fall as shares outstanding increases. Again, the market capitalization stays constant but may be subject to the butterfly effect once more.
And finally, take a look at when the company increases the shares outstanding through a stock split. In a 2:1 split, the number of shares doubles and the share price is halved. Nothing is fundamentally different with the company or the market capitalization. Current shareholders receive 2 shares for their previous share, and so even though their new shares are twice as diluted, they have double the shares and are generally unaffected.
So sometimes dilution has a negative effect to shareholders and other times it makes no difference at all. It really depends on the context of the situation.
For the actual definition of basic EPS and diluted EPS, there is no context. These definitions are black and white, so make sure you understand that. General share dilution is a completely different ballgame than diluted EPS.
Basic EPS vs. Diluted EPS
Calculating EPS is done by dividing net earnings by shares outstanding. The difference between diluted and basic lies in how you count shares outstanding. Basically the diluted EPS calculates the “worst case” scenario for shares outstanding. This is the case where the company is as diluted as it’ll ever be.
If you understand basic corporate compensation, you’ll know that many employees are paid through stock options. However, the premise of a stock option is that the employee has the choice to either exercise the option or hold it longer. Sometimes, these stock options take time to vest. It’s impossible to determine when a stock option will be exercised.
This creates a basic problem for accountants. How do you categorize a stock option? Of course it’s a share, but if it isn’t exercised, then it isn’t currently part of the total shares outstanding. But… it can be exercised at any time so it can’t just be ignored from the financial statements.
This dilemma created big problems for Wall Street during the early 2000s, until the solution was created: basic EPS and diluted EPS.
Basic EPS calculates all of the current shares outstanding without taking stock options into regard.
Diluted EPS considers every single stock option, whether it’s been exercised or not. This calculation is assuming that every stock is already exercised, and so shareholder dilution won’t be any worse than this.
When using EPS in my own fundamental analysis calculations, I always use diluted EPS. Why would I ever use a value that isn’t accurate such as basic EPS? Turns out, much of Wall Street also uses EPS, and any time you see an EPS calculation it’s generally assumed to be diluted EPS.
It’s only been a little over a decade that diluted EPS has even existed. It took much controversy and a few scandals to spurn its creation. Warren Buffett famously spoke out about this, saying “if stock options aren’t compensation, then what is it? If compensation isn’t an expense, then what is it?”
I say, if basic EPS doesn’t count all of the possible shares outstanding, then what does it count? Diluted EPS should be your only consideration, and now you know why.
**What does Diluted EPS mean?**
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