3/9/24, 11:29 AM Earnings Per Share - Learn How to Calculate Basic and Diluted EPS

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Earnings Per Share (EPS)

Each common share’s profit allocation out of the company’s total profit

Written by CFI Team

What is Earnings per Share (EPS)?

Earnings per share (EPS) is a key metric used to determine the common shareholder’s
portion of the company’s profit. EPS measures each common share’s profit allocation in
relation to the company’s total profit. IFRS uses the term “ordinary shares” to refer to
common shares.

The EPS figure is important because it is used by investors and analysts to assess company
performance, to predict future earnings, and to estimate the value of the company’s shares.
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The higher the EPS, the more profitable the company is considered to be and the more
profits are available for distribution to its shareholders.

Earnings Per Share Example

Capital Structures

Capital structures that do not include potentially dilutive securities are called simple capital
structures. On the other hand, complex capital structures include such securities.

Dilutive securities refer to any financial instrument that can be converted or can increase the
number of common shares outstanding for the company. Dilutive securities can be
convertible bonds, convertible preferred shares, or stock options or warrants.

Basic and Diluted EPS

There are two different types of earnings per share: basic and diluted. Reporting basic EPS
is required because it increases the comparability of earnings between different companies.
Diluted EPS is required to reduce moral hazard issues.
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Without diluted EPS, it would be easier for the management to mislead shareholders
regarding the profitability of the company. It is done by issuing convertible securities such as
bonds, preferred shares, and stock options that do not require issuing common shares
immediately but can lead to issuance in the future.

Basic EPS Diluted EPS

Shows how much of the company’s Amount of the company’s earnings attributable to
earnings are attributable to each each common shareholder in a hypothetical scenario
common share in which all dilutive securities are converted to
common shares

EPS = (Net income available to Amount of the company’s earnings attributable to

shareholders) / (Weighted average each common shareholder in a hypothetical scenario
number of shares outstanding) in which all dilutive securities are converted to
common shares

Basic EPS is always larger than Diluted EPS is always smaller than basic EPS
diluted EPS

Basic EPS Formula

Net income available to shareholders for EPS purposes refers to net income less dividends
on preferred shares. Dividends payable to preferred shareholders are not available to
common shareholders and must be deducted to calculate EPS.

There are two kinds of preferred shares that we need to know about: cumulative and non-
cumulative. For cumulative preferred shares, the preferred shareholder’s entitlement must
always be deducted regardless of whether they are declared or paid.

Only the current period’s dividends should be considered, not any dividend in arrears. For
non-cumulative preferred shares, the dividends should only be deducted if the dividend’s
been declared.

To determine the total number of common shares, we calculate the weighted average
number of ordinary shares outstanding. A weighted average number is used instead of a
year-end number because the number of common shares frequently changes throughout
the year.

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Consider the following example:

Assume that on January 1, 2017, XYZ Company reported the following:

Preferred shares: 1,000,000 authorized, 400,000 issued and outstanding, $4 per share per
year dividend, cumulative, convertible at the rate of 1 preferred to 5 common shares.

Common shares: 5,000,000 authorized, 800,000 issued and outstanding, no par value, and
no fixed dividend.

Calculate Basic EPS if net income was $2,234,000.

Step 1: Calculate net income available to common shareholders

Net income $2,234,000

Less: Cumulative preferred dividends ($1,600,000)

Net income available to common shareholders $634,000

Step 2: Weighted Average Number of Shares Outstanding

In our example, there are no instances of common share issuance or repurchase. Therefore,
the weighted average is equal to the number of shares outstanding: 800,000

Step 3: Apply the Basic EPS formula

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Calculating Diluted EPS

When calculating for diluted EPS, we must always consider and identify all potential ordinary
shares.

A potential ordinary share describes any financial instrument that can lead to one or more
common shares in the future. Thus, a potentially dilutive share is one that decreases EPS
because the denominator value for the number of shares increases. As mentioned before,
potential ordinary shares include:

Convertible bonds that can be converted into common shares

Convertible preferred shares that can be converted into common shares

Stock options and warrants that permit the holder to buy common shares at a
predetermined price

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When calculating for diluted EPS, we always use the if-converted method. The if-converted
method assumes that the security is converted into common shares at the beginning of the
period unless noted otherwise and that the company did not pay interest or preferred share
dividends during the year because it is assumed to be converted at the beginning of the
year.

Remember that interest on bonds payable is a tax-deductible expense while dividends on

preferred shares are not. Finally, for stock options and warrants, we must only consider
options that are “in-the-money.” They refer to options in which the exercise price is lower
than the average market price of the shares.

Video Explanation of Earnings Per Share (EPS)

Watch the short video below to quickly understand the main concepts covered here,
including what earnings per share is, the formula for EPS, and an example of EPS calculation.

Importance of Earnings Per Share (EPS)

Investors purchase the stocks of a company to earn dividends and sell the stocks in the
future at higher prices. The earning capability of a company determines the dividend
payments and the value of its stocks in the market. Hence, the earnings per share (EPS)
figure is very important for existing and prospective common shareholders.

However, a company’s real earning capability cannot be assessed by the EPS figure for one
accounting period. Investors should compute the company’s EPS for several years and
compare them with the EPS figures of other similar companies to select the most
appropriate investment option.

A company with a constant increase in its EPS figure is usually regarded to be a reliable
option for investment. Furthermore, investors should use the EPS figure in conjunction with
other ratios to estimate the future stock value of a company.

Stock Options – Good or Bad?

Many companies today issue stock options and warrants to their employees as part of their
benefits package. Would such a benefit be appealing to you or are they simply a marketing

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tactic? Although the benefits can prove to be useful, they also come with limitations. Let us
take a look at the advantages and disadvantages of stock option benefits.

Advantages Disadvantages

Addresses the issue of moral hazard – Employees may have low tolerance to
Employees are motivated to work harder risks and therefore, they may not like the
because the value of their compensation can risk inherent in stock options.
increase through better performance.

Typically, the options have a vesting period If employees do not understand the value
wherein employees can only exercise them at of the options, they will not consider it a
a later date, which helps retain employees. benefit.

If the options are exercised, employees Employees have limited abilities to affect
become shareholders, which ensures that the stock price and therefore, stock
they will act in the best interests of the options might not be motivating enough
company. for them to work hard.

Additional Resources

Thank you for reading CFI’s guide to Earnings Per Share (EPS). To increase your knowledge
and advance your career, see the following free CFI resources:

Stockholders Equity

Retained Earnings

Earnings Season

Weighted Average Shares Outstanding

See all valuation resources

See all accounting resources

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