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Diluted EPS (Earnings Per Share) in Shareholders’ Equity

Diluted EPS considers the effects on EPS of all the potential common shares that were outstanding during the year. If inclusion of these shares in the EPS calculation reduces the amount of EPS, then these potential common shares are dilutive and will be included in the calculation of diluted EPS. Otherwise, they are anti-dilutive and will be omitted from the calculation of diluted EPS. Including dilutive potential common shares in the EPS calculation may require adjustments to the numerator and the denominator of the basic EPS calculation. We will illustrate these adjustments for convertible preferred stock.

Recall from our earlier discussion that the dividends declared or accumulated during the period on preferred stock must be subtracted from net income in order to obtain the income applicable to the common shares. If the convertible preferred stock had been converted at the start of the period, however, the preferred dividends would not be subtracted from net income, and the denominator of the EPS calculation would include the additional shares that were issued on conversion. To illustrate, assume that Groucho company has a basic EPS of $5.00 per share, computed as shown in Figure 9.7.

Figure 9.7 Basic EPS Calculation

Inclusion of the potential common shares associated with the convertible preferred stock in the EPS calculation would result in a diluted EPS of $ 4.80, as follows:

Diluted EPS = Net Income / Common shares outstanding shares issuable upon conversion of preferred stock

= $48 million / 9 million shares 1 million shares

= $4.80 per share

In this case, Groucho would report on the face of the 2001 income statement a basic EPS of $5.00 and a diluted EPS of $4.80. Case study 9.3 shows the calculation of basic and dilutive EPS for a firm with potential common shares related to convertible preferred stock in its capital structure.

Case Study 9.3

Bethlehem Steel Corporation, a major steel fabricator, reports the following amounts of basic and diluted EPS in its 1997 financial statements:

Required:

a. Explain why the amounts of preferred dividends that are subtracted in order to determine net income applicable to the common shares differ between the basic and diluted EPS calculations. Why are some preferred dividends included in the diluted EPS calculation?

b. Determine the total number of potential common shares and the total preferred dividends that are associated with Bethlehem’s dilutive convertible preferred stock.

c. Based on your answer to b, determine the preferred stock dividend per potential common share, and explain why this relation causes these preferred shares to be dilutive.

d. Explain why you would consider either basic or diluted EPS to be a more useful measure of Bethlehem’s per share earnings.

Solution

a. The calculation of basic EPS requires the subtraction of all preferred stock dividends. In computing diluted EPS, the dividends on dilutive preferred stock are added back because the related potential common shares are treated as if outstanding during the period; in other words the potential common shares are added to the denominator. Some of Bethlehem’s preferred dividends remain in the calculation of diluted EPS, either because those preferred shares are not convertible to common stock, or because the EPS effects would be anti-dilutive (EPS would be higher if these shares were converted).

b. The numbers of potential common shares and the dividends on dilutive preferred stock can be determined by comparing the amounts used in computing basic and diluted EPS. The potential common shares are 14,601,000 (127,040,000 - 112,439,000), and the preferred dividend is $19,100,000 ($41,600,000 - $22,500,000).

c. The preferred stock dividend per potential common share for the dilutive preferred stock is $1.308 per share. Note that this amount is below the firm’s basic EPS of $2.13. For this reason, the inclusion of these shares in the EPS calculation reduces the measured EPS.

d. Whether basic or diluted, EPS is more useful depending in part on the likelihood that the preferred shares will be converted to common shares. This in turn depends on many factors, including the future profitability of the company.