Earnings per common share (EPS) is computed by dividing net income by the weighted average number of common shares outstanding during the period on a basic and diluted basis.
- Public companies with simple capital structure are required to report only Basic EPS, however the ones with complex capital structure (with potential dilutive securities), are required to report both basic and diluted EPS in their financial reports
Analysts give precedence to Diluted EPS in their financial analysis as against the Basic EPS. The essence of Diluted EPS is to consider all the securities (options, convertible instruments such as convertible bond, convertible preferred stocks etc.), that have a potential to be converted (basis in-the-money conversion test) into common stock and add that to the total common shares outstanding. Thus, allocating the net income to all the shareholders expected to have a claim on the bottom line.
Below is the snapshot from the latest 10-K of Starbucks as of October 03, 2021:
As can be seen in the example above, dilution usually results in a lower EPS as compared to the Basic EPS
However, as the name suggests, there are certain cases where the convertible securities have an anti-dilutive effect on EPS instead of dilutive impact. Meaning, they result in higher post conversion EPS instead of lower. I will explain such one of such cases with an excel example towards the end.
Companies exclude such securities from their Diluted EPS calculation, thereby following the principal of prudence and conservatism. Below is an excerpt from financial statement of a public company highlighting this fact.
Thus, to summarize:
- Dilution results in reduction in EPS or an increase in loss per share resulting from the assumption that convertible instruments are converted and / or options are exercised, resulting in issuance of common ordinary shares
- Antidilution results in an increase in EPS or a reduction in loss per share resulting from the assumption that convertible instruments are converted and / or options are exercised, resulting in issuance of common ordinary shares
So, How Does Anti-Dilution Exactly Happen?
It is true that when potentially dilutive securities get converted, it results in a higher common stock outstanding. This thereby has a denominator effect. However, such securities might also have a numerator effect. Let’s see how.
While looking into dilution, we mostly focus on the denominator, i.e., number of new shares created, thereby increasing the total share count (denominator effect). While most often we tend to overlook the adjustments required to be made to the Net Income due to the conversion of securities or as we call – the numerator effect.
When a bond or preferred shares are issued, it promises the investors a fixed return in the form of coupon rate or dividend which are deducted from the numerator (Net Income), before using it for the EPS calculation. However, if we assume that these securities are no longer interest or dividend bearing securities and are common shares instead, we need to add back the interest / dividend so deducted from the numerator to make apples to apples adjustments.
If the numerator effect is larger than the denominator effect, it results in higher EPS and hence is anti-dilutive.
Some security instruments have provisions or ownership rights that allow the owners to purchase additional shares when another security mechanism would otherwise dilute their ownership interests. These are often called anti-dilution provisions.
Guidance on Calculating Dilution Impact
Compare the Basic EPS with the Diluted EPS (basis the detailed adjustments scenarios provided below.
- If Basic EPS > Diluted EPS >> Dilutive Impact (Include)
- If Basic EPS < Diluted EPS >> Anti-Dilutive Impact (Do not include)
Case 1: Options and Warrants: Always results in dilution if the securities are in-the-money
- Numerator: No Impact
- Denominator: Check for in-the-money test and apply treasury stock method to calculate the total dilution impact
Case 2: Convertible Debt: Can be dilutive or anti-dilutive depending upon the numerator vs denominator effect
- Numerator: Adjusted for the after-tax effect of interest charged
- Denominator: Includes shares that would be issued on the conversion of debt
Case 3: Convertible Preferred Shares: Can be dilutive or anti-dilutive depending upon the numerator vs denominator effect
- Numerator: Adjusted for the dividend charged
- Denominator: Include shares that would be issued on the conversion of preferred stock
Case 4: Convertible Preferred Shares: Can be dilutive or anti-dilutive depending upon the numerator vs denominator effect
- Numerator: Adjusted for the dividend charged and after-tax effect of interest charged
- Denominator: Include shares that would be issued on the conversion of preferred stock and convertible debt
Quick Test : Dilutive vs Anti-Dilutive
Calculate the Basic Shares and Compare with the Conversion ratio of each security. Where, conversion ratio is incremental change in numerator / incremental change in denominator
- Preferred Stock: If Increase in Numerator (Preferred Dividend) / Increase in Denominator (New Shares Issued) is < Basic EPS >>> Dilutive, else anti-dilutive
- Convertible Debt: If Increase in Numerator (Interest Expense * (1-Tax Rate)) / Increase in Denominator (New Shares Issued) is < Basic EPS >>> Dilutive, else anti-dilutive
Note: If there are multiple convertibles, then rank all the convertible securities by the conversion ratio and select only the ones which have the conversion ratio less than Basic EPS. For example, if Basic EPS is 3.2 and post-tax interest expense for a convertible bond is 60 and resulting increase in number of shares is 25, then conversion ratio is 60 / 25 = 2.4, which is < Basic EPS, hence the impact of such security will be dilutive.
If there are multiple securities, with conversion ratios as 2.4, 2.8, 3.6 and 4.2, the only first two are dilutive and remaining are anti-dilutive.
Practice Questions: (Solutions are in the attached excel)
Ques 1. Company A has a Net Income of $275,000 and 65,000 shares outstanding. Company also has 150 convertible debentures of $750 par value with a coupon rate of 6%. Each debenture can be converted to 20 shares. Company has a marginal tax rate of 25%. What is the company’s basic and diluted EPS.
Ques 2. What would be the new EPS, if in addition to this company also had $150,000 non-convertible preferred shares with 12% dividend.
Ques 3. How would the impact change if the preferred shares were convertible, with each preferred share being converted to 5 ordinary shares. Face value of preferred shares is $10 each.
Financial Fudge 