Diluted Earnings Per Share - Diluted EPS

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What is 'Diluted Earnings Per Share - Diluted EPS'

Diluted EPS is a performance metric used to gauge the quality of a company's earnings per share (EPS) if all convertible securities were exercised. Convertible securities are all outstanding convertible preferred shares, convertible debentures, stock options (primarily employee-based) and warrants. Unless the company has no additional potential shares outstanding, which is a relatively rare circumstance, the diluted EPS will always be lower than the simple EPS.

BREAKING DOWN 'Diluted Earnings Per Share - Diluted EPS'

Diluted EPS takes into account what would happen if dilutive securities were exercised. Dilutive securities are securities that are not common stock but can be converted to common stock if the holder exercises that option. If converted, dilutive securities effectively increase the weighted number of shares outstanding, and this in turn decreases EPS, because the calculation for EPS uses a weighted number of shares in the denominator.

Significance of EPS

EPS is a very important measure used in assessing a company's financial health. When reporting financial results, revenue and EPS are two of the most commonly assessed metrics. In their earnings reports, companies report both primary and diluted EPS, but the focus is generally more on the more conservative diluted EPS measure. Dilutive EPS is considered a conservative metric because it indicates a worst-case scenario in terms of EPS.

It is highly unlikely that everyone holding options, warrants, convertible preferred shares, etc. would convert their shares all at once. At the same time, if things go well, there is a good chance that all options and convertibles will be converted into common stock. A big difference in a company's EPS and diluted EPS can indicate high potential dilution for the company's shares, an attribute almost unanimously looked upon negatively by both analysts and investors. An important caveat is that EPS is only required to be reported by public companies. EPS is reported in a public company's income statement.

Common Dilutive Securities

Convertible preferred stock, stock options and convertible bonds are common types of dilutive securities. Convertible preferred stock is a preferred share that can be converted to a common share at any time. Stock options are common employee benefits, particularly for executives. Stock options grant the holder the right to purchase common stock at a set price at a set time. Convertible bonds are similar to convertible preferred stock, as they are converted to common shares at the prices and times specified in their contracts. All of these securities, if exercised, would increase the number of shares outstanding, and would therefore decrease EPS.