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Friday, August 17, 2018

Basic EPS Vs Diluted EPS

While the calculation of Intrinsic Value of a Stock may be very well structured, there are many varieties of Earnings Per Share being used these days, and investors must understand what each one represents if they are to make informed investment decisions.

The EPS announced by a company may differ significantly from what is reported in the financial statements and in the headlines. As a result, a stock may appear over- or undervalued depending on the EPS being used. It is better we understand the EPS and its types a little more in detail

What is EPS?
By definition, EPS is the net income divided by the number of shares outstanding. However, both the numerator and denominator can change depending on how you define "earnings" and "shares outstanding." There are numerous ways to define both - the earnings, as well as the shares outstanding.
In this article, we are focusing on the types of EPS based on "shares outstanding". The key, for you, is to understand what EPS you are taking for your calculations and stay focused on the same type of EPS for all companies that you are evaluating- while filtering out the intense noise and data round you. Let us look at some of the EPS types based on shares outstanding:

Primary or Basic EPS
Primary or Basic EPS is calculated using the number of shares that have been issued and are currently held by investors. These are the shares that are currently in the market and can be traded. So, assuming these outstanding shares, we calculate the Basic EPS.
If the company earned $500 million and had 250 million shares of stock issued and outstanding, Basic EPS would be $2.00, because $500 million profit divided by 250 million shares = $2.00.

Diluted EPS
Diluted EPS entails a relatively complex calculation that determines how many shares 'would be' outstanding, in addition to the current ones, if all exercisable warrants, stock options and convertible bonds were converted into shares at a point in time, generally the end of a quarter. A company's Diluted EPS is the same thing as Basic EPS except the shares outstanding figure is adjusted to include shares that might or will be issued in the future. If a company has a significant amount of potential dilution lurking in the books, the "real" EPS figure would be lower than the basic EPS figure in profitable years because the net income would need to be split by more shares. 
Some investors tend to prefer diluted EPS because it is a more conservative number, and looks into the future.

Basic EPS Vs Diluted EPS

Basic EPS is always higher than diluted EPS since in diluted EPS all convertible securities* are added to the common shares in the denominator.

A convertible security is a security that can be converted into another security. Convertible securities may be convertible bonds or preferred stocks that pay regular interest and can be converted into shares of common stock (sometimes conditioned on the stock price appreciating to a predetermined level).

In most cases, Basic EPS is the 'real time' picture and Diluted EPS is the futuristic picture. I, personally, use Basic EPS for Intrinsic Value calculations, and use Diluted EPS for projections if the difference is significant.


Manoj Arora
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