Diluted Earnings Per Share: Convertibles and Stock Options Explained | CFA Level I FSA
From basic EPS, let’s dive into diluted EPS, accounting for convertible preferred stock, convertible bonds, and stock options that can dilute a company’s earnings per share.
Convertible Preferred Stock and Diluted EPS
Diluted EPS is calculated using the if-converted method, considering the effects of convertible preferred shares. If the convertible preferred shares had been converted, we would have two effects:
- No more convertible preferred shares, but additional common stock outstanding.
- No preferred dividends paid on converted shares, freeing up income for common shareholders.
EXAMPLE
Compute the basic and diluted EPS for Complicated Inc., given their financial information:
- Net income: $100,000
- Common stock: 50,000 shares
- Convertible preferred stock: 1,000 shares
- Preferred shares: $100 par value, 5% dividend, convertible to 25 common shares
Following the calculation steps, we find:
- Basic EPS: $1.90
- Diluted EPS: $1.33 (lower than basic EPS, thus dilutive)
Convertible Bonds and Diluted EPS
For convertible bonds, diluted EPS is also calculated using the if-converted method. If the convertible bonds had been converted, we would have two effects:
- No more convertible bonds, but additional common stock outstanding.
- No interest paid on convertible debt, but taxable income increases.
EXAMPLE
Compute the basic and diluted EPS for Obligated Inc., given their financial information:
- Net income: $100,000
- Common stock: 50,000 shares
- Convertible bonds: 200 bonds
- Bonds: $1,000 par value, 3% interest, convertible to 100 common shares
- Tax rate: 30%
Following the calculation steps, we find:
- Basic EPS: $2.00
- Diluted EPS: $1.49 (lower than basic EPS, thus dilutive)
Stock Options and Diluted EPS
For stock options, diluted EPS is calculated using the treasury stock method, which considers the net increase in common shares upon exercising stock options.
EXAMPLE
Compute the basic and diluted EPS for Arbitrary Inc., given their financial information:
- Net income: $100,000
- Common stock: 50,000 shares
- Stock options: 3,000 options
- Option conversion price: $30 per share
- Average stock price: $40
Following the calculation steps, we find:
- Basic EPS: $2.00
- Diluted EPS: $1.97 (lower than basic EPS, thus dilutive)
Multiple Dilutive Securities and Diluted EPS
If a company has multiple dilutive securities, we adjust the numerator and denominator accordingly:
- Convertible preferred stocks: Add back convertible preferred dividends to the numerator and the increase in common shares to the denominator.
- Convertible bonds: Add back the after-tax bond interest to the numerator and the increase in common shares to the denominator.
- Stock options or warrants: Add the net increase in shares using the treasury stock method to the denominator.
Remember, examine each potentially dilutive security independently and include it in the diluted EPS computation only if it is actually dilutive.
And that wraps up our lesson on diluted EPS. Now you have a better understanding of how convertible preferred stock, convertible bonds, and stock options can affect a company’s earnings per share. In our next lesson, we’ll discuss some analytical tools for income statement analysis.
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