Both Basic EPS and Diluted EPS are important profitability measures that help in the analysis of the companies. It is necessary to know the difference between Basic vs Diluted EPS to analyze the income statement correctly. Before we go into the differences, it is crucial that we know what EPS, Basic EPS and Diluted EPS are.
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There are two ways of looking at a profit that the business generates. First is the total profit that the company generates. And second, is how much of that profit makes its way to the shareholders. A business may be making good profits, but it would be meaningful if each shareholder enjoys a good profit both in terms of ROI and absolute terms i.e. earnings per share. To know the results on a per-share basis, we calculate the EPS.
EPS stands for Earnings Per Share, or the income attributable to each share. It is an extremely important measure for the investors and analysts to pick a stock. One can calculate EPS by dividing the net income (Less Dividend on Preference Shares) by the total outstanding shares (average).
A high EPS number could mean that the company has funds to reinvest in the business or payout as dividend. Thus, the EPS number that a company reports can cause significant fluctuations in its stock price.
Basic EPS is the same as the EPS. It simply measures the earnings per share without making any type of adjustments. The formula for calculating the basic EPS is the same as above. For calculating Basic EPS, we only consider the company’s common shares. It is a great indicator of the financial health and stock price, and a high EPS means that it is a good investment.
For calculating the Diluted EPS, along with the outstanding shares, we also consider convertible securities. Here convertible securities mean a change in the outstanding shares if all sources of conversion are exercised. These convertible securities may include employee stock options, convertible debt, convertible bonds, stock options, convertible preferred shares, warrants and more. Dilutive effects increase the number of shares.
It can be difficult to calculate Diluted EPS. To calculate it, an accountant will first have to calculate the cost to exercise these options and other things, like strike price.
Basic vs Diluted EPS – Differences
Basic EPS is a tool that calculates the basic earnings per equity share. On the other hand, the Diluted EPS is a barometer that determines the earnings per convertible share along with the quality of earnings per share.
The main objective of the Basic EPS is to calculate the profitability of the company. Diluted EPS measures the profitability by including convertible securities.
Importance to Investors
Many see Diluted EPS as more important as it includes convertible securities in the calculation.
We only use common shares for calculating Basic EPS. For Diluted EPS, we use common shares, preferred shares, warrants, debt, stock options and more. Value of Basic EPS is always more than the Diluted EPS because the numerator is the same in both, but the denominator increases in the latter.
There is no assumption is calculating Basic EPS. However, for calculating Diluted EPS, one assumes that all the convertible securities will be exercised.
Ease of Use
Basic EPS is simple to use and calculate. On the other hand, Diluted EPS is much more complex and involves a lot of calculation.
Company A has 20,000,000 shares outstanding at the start of the year and 15,000,000 shares outstanding at the end of the year. The net income is $100,000,000. In this case, Basic EPS is ($100,000,000 ÷ ([20,000,000 + 15,000,000] ÷ 2)) $5.71.
In the same example, if 5,000,000 shares are held by an investor for conversion, then Diluted EPS is ($100,000,000 ÷ ([[20,000,000 + 15,000,000] + 5,000,000] ÷ 2)) $4.44.
Basic vs Diluted EPS – Why It’s Important?
For investor and analysts, it is very important to understand the difference between the two. If you pick a wrong EPS figure, you may end with a misleading PE (price to earnings ratio), dividend-adjusted PEG ratio, PEG ratio and more. Calculation of all these ratios involve the use the EPS, and all these ratios are very important for calculating the financial health of a company.
Moreover, the FASB (Financial Accounting Standard Board) has made it mandatory for the companies to report Basic and Diluted EPS every quarter. So, it is a must for analysts and investors to know about each of them.
We now know that Basic EPS is a simple indicator of the financial health of a company. On the other hand, Diluted EPS goes into more detail to give earnings per share. Many see Diluted EPS as superior as it reveals how the company would perform if the investors exercise all the convertible securities.
For better understanding, one can calculate both the EPS figures. If a major difference comes between the two numbers, then one should carry further investigations. This difference could mean that a significant amount of income is not available to the investors as it is tied up with the convertible securities.1,2