For a long time, Indian companies did not report diluted EPS of their business. We all know about the concept of EPS. It is the earnings per share issued by the company. In terms of a formula, an EPS can be written as under:
Basic EPS = (Net Income – Preferred Dividend) / Outstanding Common Shares
So if a company has a net profit of Rs.20 crore and has 1 crore shares issued and outstanding then the EPS is Rs.20/share. This is an important measure because it goes into measuring the P/E ratio which is an important valuation metrics for stocks. But for a long time, Indian companies were only required to show their EPS in terms of Basic EPS. This formula had a problem. It calculated the EPs based on the outstanding shares in the market but there could be many potential sources of dilution of equity. For example, the company may have issued convertible debentures which, if converted will increase the number of outstanding shares. Alternatively, the company may have issued warrants which if exercised may result in dilution of equity. All these potential dilutions are captured by Diluted EPS and hence it gives a much better picture of what the company is actually earning per share.
Diluted EPS = (Net Income + Convertible Preferred Dividend + Debt Interest) /
All convertible securities plus common shares
Let us now look at the basic and diluted EPS formula as well as the differences bet basic and diluted EPS. Here is a quick take on the diluted EPS vs basic EPS debate.
What we need to know about the key differences between the two EPS
There are a few key points to be understood when we look at basic EPS versus the diluted EPS:
Basic EPS is a simple measure of profitability and hence it is a lot better understood even for lay investors. Diluted EPS, on the other hand, is a more complex measure. Most retail and small investors find it hard to interpret and understand the logic behind a diluted EPS calculation.
Basic EPS may be simpler but it is not a very sound and realistic approach to find out the potential value of a company. More so, since this EPS is going to be used as the denominator for the calculation of the P/E valuation metrics! Diluted EPS gives a more realistic picture of how much the company is earning on total capital employed after considering dilution. Companies cannot get away with financial engineering by issuing preference shares or convertibles and not show the potential dilution effect.
Actual calculation of diluted EPS is a lot more complicated and needs a lot more data points. Basic EPS can be calculated just by subtracting the preferred dividend from the net income and then by dividing with the outstanding equity shares. Diluted EPS, on the other hand, can be calculated by adding net income, convertible preferred dividend, and debt interest and dividing the sum by outstanding shares plus the impact of dilution as a result of all convertible securities of the company.
Basic EPS is perfectly set for companies which have a simple capital structure. If you do not have convertibles or other potential diluters like warrants then Basic EPS is good enough. However, larger companies do have a more complex capital structure and hence in such cases, the Diluted EPS is more meaningful.
Basic EPS is always higher than diluted EPS and at best the Diluted EPS can be equal to the Basic EPS. That is because; in diluted EPS all convertible securities are added to the common shares in the denominator.
How to practically apply Basic EPS versus Diluted EPS
Remember, EPS is the first step to calculating the P/E Ratio as a valuation metrics. Hence the more granular and precise you are calculating the EPS, the better it is.
While the basic EPS is a good measure of current profitability, the diluted EPS is more scientific as it also includes potential dilutions and shareholders are not in for a very nasty surprise.
From an analytical point of view, the diluted EPS can be more useful as it covers the combined impact of all potential dilutions and hence shows the company's EPS restated for future capital expansion. This makes the P/E more realistic.
While basic EPS considers only the issued and outstanding Common shares of the company, the diluted EPS imputes the impact of Common share price, preferred shares, stock options, warrants, partially convertible debt, fully convertible debt etc.
The finer distinction between basic EPS and diluted EPS is actually meaningful only if it is resulting in significant dilution. Otherwise, for all practical purposes, the basic EPS serves your purpose well enough.