If there is a large difference between a company's basic earnings per share (EPS) and its diluted EPS, it signifies that the company has a large number of securities that could be converted to common shares.
Basic EPS is a measurement of a company's profit, which can be allocated to one common share of its stock. The basic EPS calculation does not take into account convertible securities, which could dilute a company if exercised. To calculate a company's basic EPS, divide its net income less any preferred dividends by the weighted average number of common shares.
On the other hand, diluted EPS takes into account convertible securities and is a more conservative measure of earnings than the basic EPS. Diluted EPS is a metric used in fundamental analysis to gauge a company's EPS, if all convertible securities are exercised.
The formula used to calculate a company's diluted EPS is a company's net income less preferred dividends divided by the weighted average number of fully diluted common shares outstanding. Generally, if a company has convertible securities, the diluted EPS will be less than its basic EPS. If there is a large discrepancy between a company's basic EPS and diluted EPS, it indicates that the company has a high potential of dilution of its common shares, if all convertible securities are exercised.
For example, assume company XYZ has common shares outstanding of 5 million shares, employee stock options that could be converted to 8 million common shares and convertible preferred shares that could be converted to 10 million common shares. Company XYZ had a net income of $5 million and did not pay any dividends.
The basic EPS is $1 per share ($5 million/5 million). On the other hand, the diluted EPS for company ABC is 22 cents (($5000000 - 0)/(5000000 + 8000000 + 10000000)) per share.