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 do 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.
The EPS Formula:
= Earnings Per Share
= Earnings (“Net Income”) / Shares Outstanding
The Diluted EPS Formula:
= Diluted Earnings Per Share
= Earnings “Net Income” / Diluted Shares Outstanding
The Basic EPS Formula:
= Basic Earnings Per Share
= Earnings “Net Income” / Basic Shares Outstanding
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.
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.
Share price * shares outstanding = market capitalization,
and EPS * shares outstanding = 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.
A company can issue more shares or buy back stock; the first dilutes EPS and increases shares outstanding, while the latter decreases shares outstanding. In these situations, 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 is technically true, but because the EPS increases as shares outstanding decreases, the stock price tends to rise to that new EPS valuation.
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 might see share price fall as shares outstanding increases.
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 1 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 earnings, “net income”, 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 was only a little after the turn of the millennium that diluted EPS was invented. It took much controversy and a few scandals to spurn its creation. Warren Buffett famously spoke out about stock-based compensation, 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.