Terms Beginning With 'd'

Diluted Earnings per Share

Diluted earnings per share is a type of earnings per share that is calculated considering all the convertible instruments such as convertible preferred shares, convertible debt, stock options, and right issues. Ideally, if a company does not have any convertible instrument outstanding, its basic earnings per share (or EPS) should be equal to its diluted earnings per share.

By definition, the diluted EPS of a company is always less or equal to the basic EPS; however, if a company has anti-dilutive instruments, the diluted EPS could be higher than the basic EPS. Under the financial reporting standards, i.e., IFRS and US GAAP, companies are required to disclose both basic and diluted EPS on the income statement.

 Calculating Diluted EPS for Various Dilutive Instruments

A majority of formulae used to calculate the diluted EPS of a company work on an if-converted method, that is, based on what EPS would have been of the convertible instrument under consideration if it is converted at the beginning of the period.

  • Diluted EPS for Convertible Preferred Stocks

As suggested above, the calculation of diluted EPS when a company has convertible preferred stocks outstanding involves an if-converted method and assumes that the convertible preferred stocks had been converted at the beginning of the period.

If we use the if-converted method and assume that the convertible preferred stocks have been converted at the beginning of a period, it will leave two effects:

  1. The convertible preferred stocks will no longer be outstanding; instead, additional common stocks will be outstanding (leading to a dilution in basic EPS).
  2. If such a conversion took place, the company would not be paying any preferred dividends.

Therefore, if the above two effects take place, the number of shares outstanding would increase along with the net income available for distribution among common shareholders.

Thus, diluted EPS for such instruments could be calculated as below:

For example, suppose a company had a net income of $100,000 and an average of 100,000 shares of common stock. Let’s assume for simplicity that the company pays a preferred dividend of $1 on 200 preferred shares (convertible into five common shares)

Under the if-converted method:

  • Diluted EPS for Convertible Debt Outstanding

When a company has convertible debt outstanding, the diluted EPS calculation once again considers the if-converted method, and diluted EPS is calculated as if the convertible debt outstanding had been converted at the beginning of the period.

So, if a company’s convertible debt is converted at the beginning of the period, it will leave two effects:

  1. The company’s debt would no longer exist, and it will not pay any interest on the converted debt. Therefore, the net income available for common shareholders will increase by the after-tax amount of interest expense on debt converted.
  2. Additional common shares will be issued and outstanding.

Thus, the calculation of diluted EPS under the if-converted method for convertible debt outstanding would be as below:

For example, suppose a company has a net income of $750,000 and a weighted average shares of 690,000 at the end of a period. For simplicity, let us assume that the company has only one dilutive debt of $50,000 @ 6 per cent of convertible debt, convertible into 10,000 shares. (Tax rate = 30 per cent)

Under the if-converted method:

  • Diluted EPS For Stock Options, Warrants, Or Equivalent Outstanding

Just like the other two cases, if a company has stock options, warrants, or equivalent outstanding, the calculation again involves the if-converted method with a slight modification.

It is assumed that if a company has these dilutive instruments, it will convert the same at the beginning of the period and use the proceeds for repurchasing as many common shares as possible at the average market price.

The weighted average number of shares thus increases by the difference of outstanding shares minus the number of shares repurchased. Once a company dilutes such instruments, it will leave two effects:

  1. The company will receive cash upon exercising.
  2. The company is assumed to use the proceeds to repurchase shares from the market during the period at a weighted average market price.

Thus, the calculation of diluted EPS under the if-converted method for such instruments is as below:

For example, suppose a company has a net income of $2,300,000 and a weighted average of 800,000 shares at the end of a period. let us assume that the company has only one dilutive stock options @ 30,000 options at an exercise price of $35. Also, let us assume that the market price of the company’s shares averaged $55 per share.

Under the if-converted method:

Issues With Diluted EPS

The only issue which diluted EPS faces is the impact of anti-dilutive convertible securities as their inclusion into the calculation of diluted EPS would lead to a higher diluted EPS as compared to the basic EPS.

Under major financial reporting standards such as IFRS and US GAAP, anti-dilutive securities are not included in the calculation of diluted EPS. Ideally, diluted EPS should reflect the maximum dilution impact on basic EPS.

Furthermore, EPS is sensitive to change in the net income and a change in the number of outstanding shares, i.e., an increase in the net income or a decline in the number of outstanding shares or a combination of both could impact the y-o-y change in EPS.

Thus, it becomes paramount to understand and analyse EPS in the cross-sectional and time-series setting as a higher EPS does not necessarily reflect the true profitability on a standalone basis.

Earnings reflect after-tax income for a company and generally referred as the bottom line. Earnings are one of the main drivers of a company?s share as it, along with other measures, indicate the profitability of a company and its long-term sustainability.

An earnings announcement is a public statement of a company’s earnings, usually done on a periodic basis. These official announcements are released quarterly or yearly to inform the investors and the market about a company’s financial performance. Companies announce their financial reports through press releases on their websites and list them on the stock exchanges website. After the information is released through a conference call, there is a question-and-answer round with the senior management in which analysts, media, and investors can participate. On the basis of the report, analysts then incorporate earning measures such as EPS (Earning Per Share). These reports help investors in making sound investment decisions. Earnings results are announced during the earnings season on a date chosen by the company. Stock prices of the companies take a swing before and after the company releases its earnings report. Equity analysts also predict earnings estimates through their analysis which drives stock prices movement due to speculations. Stock prices even move after the earning results are declared, up or down, depending on how the results have turned out. Source: Copyright © 2021 Kalkine Media Pty Ltd. When are earning announcements made? It is mandatory for every listed company to report its quarterly financial results in the US but not in Australia. In Australia, companies release their financial report on a semi-annual basis. Having said that, many Australian companies also update their shareholders quarterly, but these are not considered official earnings. These quarterly reports are released to satisfy the market demand for information and to disclose the company’s guidance on its performance. The financial calendar varies from country to country and therefore, the earnings season changes as well. In the US, the earnings season starts after the final month of the financial quarter. Usually, American companies start posting their earnings reports in January, April, July, and October. In Australia, companies report twice a year, usually around February and August, or May and October. It depends upon the company’s financial cycle. However, whether quarterly in the US or semi-annually in Australia, these earnings results are required as agreed while listing the company with the stock exchanges. Source: Copyright © 2021 Kalkine Media Pty Ltd. Why are earnings announcements necessary? Financial results help investors, media, and other stakeholders of the company to have a greater understanding of the company’s financial footing. Companies not just provide sales, operating profit, net profits, but also offer guidance and outlook for coming months. Additionally, these reports also have senior management statements directed at the market. Therefore, earning announcements act as an informative document for the investors and analysts to study and gauge a company’s performance. Analysts can provide earnings estimates, and investors can then take wise investment decisions. These documents are also vital for companies when it comes to seeking funding for the business. Financial institutions can also judge a company’s financial health by evaluating earnings reports. The management offers insights on growth drivers, risk factors, etc that impacted the earnings during that particular period. Analysts also assess the earnings results, taking into account the external factors that drove the growth or impacted the firm negatively. These factors could be mergers and acquisitions, bankruptcies, economic discrepancies, policy changes, etc. For investors, earnings reports are essential because these announcements swing the price up or down. Traders keep a keen eye on these reports as it can be a time when they can confirm positions. However, some investors also avoid earnings seasons because of the involvement of various human factors.

Earnings Before Interest Taxes and Amortisation (or EBITA) is an operating performance measure of a company, which assist investors in comparing companies stripped of their capital allocation decisions, post considering the depreciation into account.

Earnings before interest and taxes (or EBIT) is also called the operating income that reflects the revenue generated by the business after considering all the operating expenses, i.e., revenue minus operating expense, and is a measure of operating earnings or profit before interest and taxes. Financial analysts generally use EBIT to analyse the performance of the core operations of a company without incorporating the costs of the capital structure and tax.

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