Introduction
The right to equality is a basic fundamental right. This right is most times exercised by authorities like parents, teachers etc. on most occasions. It is fair to say that even amongst friends, this right needs to be practised. It is a common occurrence that in a group, one of the members gets a new toy and feels the obligation to share it with the other members. It was a bey-blade in our group. When my best friend got it, all of us watched in fascination as she kept throwing it around, the intricate tiny thing spinning all over. We decided to take turns playing with it. The order was alphabetical and we had fun. However, one of my other friends decided since she had a cat who was also an honorary member of the group, she would take the cat’s turn as well. The hiatus ensued and we stopped playing altogether. Was she right to demand a right of equality though?
I don’t think so. Firstly, the cat is not human. Secondly, it was a cat. A stupid cat that lazed around all day long and barely moved its whiskers! Thirdly, it would have been fine if the cat demanded the right for itself and proved it could play with the toy. That would have been quite cool and would be a proper execution of the right to equality. That was the counter-argument posed to the friend, who took it as an excuse to leave the group with her pet. It was not a big deal since we made up the next week and decided to move past it. To have equality addressed is important. Equal distribution is vital for sustainability. Financial establishments do it too. When a company does well in the market, the profits gained are equally divided amongst the shares. Such profits are known as earnings per share.
Basic EPS vs Diluted EPS
Earnings Per Share or EPS can be of the basic variety or the dilute type. These are profitability measures used by companies for the fundamental analysis of the company. The difference between the two is that basic EPS takes into account the common shares of the company, while the diluted EPS takes into account all the convertible securities like the convertible bonds, and convertible preferred stock, which are converted into equity or common stock. There are more differences between the two terms.
Differences Between Basic EPS and Diluted EPS in a Tabular Form
Parameters of Comparison | Basic EPS | Diluted EPS |
Definition | Earnings per share or EPS is the company’s earnings per equity share. | Diluted earnings per share or diluted EPS is the company’s earnings per convertible share. |
Purpose | EPS has the goal of finding out the profitability of a company. | Diluted EPS has the goal of finding out the profitability of the company with the inclusion of convertible shares. |
Significance to investors | EPS is not as significant to the investors as it does not include the convertible shares. | Diluted EPS is very significant to the investors as it includes the convertible shares. |
Consideration | EPS only considers the common shares. | Diluted EPS considers common shares, preferred shares, stock options, debts, warrants etc. |
Calculation | EPS = (Net Income – Preferred Stock Dividends) / Outstanding Common Shares | Diluted EPS = (Net Income – Preferred Stock Dividends) / (Average Outstanding Shares + Dilutive Shares) |
Value | The value of the measure is high for Basic EPS as the denominator is only the common shares. | The value of the measure is lower for Diluted EPS as the denominator includes all convertible securities. |
Complexity | Basic EPS is easy to understand and calculate. | Diluted EPS is complex to understand and complex. |
What is Basic EPS?
EPS stands for earnings per share. It is a profitability measure used for fundamental analysis i.e., basic EPS measures the amount of a company’s profit gained on a per-share basis. It tells the investors how much of the company’s net income was allotted per common share of the company. It is generally reported in the company’s income statement and is useful for businesses that have only common stock in their capital structure. Such businesses need only reveal this ratio to showcase their profits.
Basic EPS does not factor in convertible securities like diluted EPS; thus, it has no dilutive effects. In a company, dilutive effects occur when the number of shares rises. For example, when the company issues new shares, the number of outstanding shares increases and the EPS reduces. Ultimately, the stock price falls.
The calculation of basic EPS is easy. The cumulative preferred dividends are subtracted from the net income and the result is divided by the number weighted average of the common shares.
Basic EPS = (Net Income – Preferred Dividends) / Weight average of Common Shares
An example is as follows:
A business X has 100 million rupees as the net income for the common shares of the last fiscal year and did not pay dividends. At the start of the year, they had 25 million shares outstanding and by the end of it, had 15 million shares outstanding.
Substituting the values for the above formula,
Basic EPS = (100 -0)/ (25+15/2) = 100 / 20 = 5 rupees.
Thus, the basic EPS for this company is Rupees 5.
What is Diluted EPS?
Diluted Earnings Per Share (EPS) are the portion of profits given to the investors by the company. Knowing the diluted EPS is essential when one is making calculations with their stocks. Diluted EPS is used in analyzing the company’s quality of EPS, assuming that all the convertible securities have been taken into consideration. It can be compared to a pie or a cake. If more slices are cut to include the additional number of people, the size of the cake for each person gets smaller.
Profits get diluted for many reasons. For example, a company might issue new shares in the event of a merger, employees may have stock with an ending vesting period or there might be securities convertible securities – outstanding convertible preferred stock, convertible debentures, warrants etc. There is always a risk of EPS dilution, which is why many analysts prefer diluted EPS for their calculations since it is more comprehensive and indicates a worst-case scenario in terms of the EPS.
Diluted EPS are not the common stock instead, they have convertible securities that can be converted into common stock. But, converting securities reduces the value of EPS. This is the reason the value of diluted EPS is always lesser than the basic EPS. Dilute EPS reduces the portion a share could offer a shareholder as they increase the number of common shares outstanding without being given as common shares.
To calculate diluted EPS is more complicated. Diluted EPS is calculated by adjusting the basic EPS figure by adding all the potential dilution. To calculate the diluted EPS, the company’s net income is taken and the preferred dividends are subtracted from it. The result is divided by the sum of the weighted average number of shares outstanding and the convertible securities like warrants, debts etc.
Diluted EPS = (Net Income – Preferred Stock Dividends) / (Average Outstanding Shares + Dilutive Shares)
An example is as follows:
Company Y has 50 million rupees as its net income over the last year and does not pay any dividends. The number of outstanding shares is 15 million. In addition to the outstanding shares, Company Y offers an employee stock option that could be converted into 1 million additional common shares and convertible preferred stock that could be converted into 4 million common shares.
Substituting the values for the above formula,
Diluted EPS = (50 – 0) / (15+1+4) = 50 / 20 = 2.5 rupees.
Thus, the diluted EPS is 2.5 rupees.
Usually, when a company has dilutive securities, the diluted EPS is always lesser than the basic EPS, be it in profit or loss. In the case of profits, the profits have to be divided among the shares. In case of losses, the diluted EPS will show a lower loss than basic EPS because the loss, as well, is spread amongst the shares.
Diluted EPS makes the investor aware of how they may be impacted in the future. Especially for investors interested in dividends. A company might make profits but decide to spare a little of that profit amongst the shareholders. This is not good for an investor interested in dividends but for one who is interested in rising share values.
Main Differences Between Basic EPS and Diluted EPS In Points
Following are the main differences between basic EPS and diluted EPS:
- Basic EPS is the measure of the company’s earnings per share, while diluted EPS is the earnings of common shares and convertible securities.
- Basic EPS has the purpose of finding the profitability of the company with the common shares, whereas the purpose of diluted EPS is to find out the profitability of the company with the convertible shares included.
- To investors, basic EPS is not as significant as diluted EPS as it does not include convertible securities.
- Basic EPS only considers only common shares, while diluted EPS is more comprehensive. It includes convertible securities, warrants, debts, preferred shares and common shares.
- Basic EPS can be calculated with the formula:
- Basic EPS = (Net Income – Preferred Stock Dividends) / Outstanding Common Shares
- Diluted EPS can be calculated with the formula:
- Diluted EPS = (Net Income – Preferred Stock Dividends) / (Average Outstanding Shares + Dilutive Shares)
- Basic EPS has a higher value measure since the denominator only consists of the common shares. Diluted EPS, on the other hand, has a lower value since the denominator has convertible securities added to it.
- Basic EPS is easy to comprehend and calculate, while diluted EPS is more complex.
- The Diluted EPS is always lesser than the basic EPS be it in the case of the company’s profit or loss.
Conclusion
Basic EPS and Diluted EPS both give information about how profitable a company is. Basic EPS is the measure of the amount of the company’s profit on a per-share basis. It takes into account only the common shares. To calculate the basic EPS, the net income of the company is taken and the preferred stock dividends are subtracted from it. The result is then divided by the weighted average number of shares outstanding. To calculate basic EPS is fairly easy.
Conversely, for diluted EPS, the calculation is more complex. Diluted EPS are the portion of profits that the investors receive. It considers all the convertible securities like warrants, debts, convertible preferred stock etc. Dilutive effects occur in a company when the number of shares increases like in the case of the issue of new shares. Generally, there is always a risk of dilution. For this reason, analysts prefer using the diluted EPS to navigate the profitability of a company since it indicates the worst-case scenario when it comes to EPS. To calculate diluted EPS, the net income of the company is taken and the preferred stock dividends are subtracted (same as in the calculation of basic EPS). The result is then divided by the sum of the weighted average number of shares outstanding and the dilutive shares like convertible preferred shares or options etc. since the denominator is always higher than that of the calculation of the basic EPS, the value of the diluted EPS is always lower. While both measure profitability of a company, diluted EPS is considered more comprehensive. The profit value may be lesser, but it serves to show the equal distribution of the profits amongst the shares (common and convertible). It is like allowing the cat to play. But I still maintain it. If the cat could play, we would all be thrilled and include it. But it couldn’t. It can’t. And as sad as that is, it does not give the owner to claim the cat’s right for their own. That would be unfair to the others and the silly cat.