Earnings per share (EPS) measures how well a company is using money invested in it when it went public. Diluted EPS takes into account the possibility of stock options and convertible bonds increasing the total number of shares, making it easier to compare companies on an equal footing. Two adjustments are made to the basic EPS calculation to account for this.
Diluted earnings per share is a measure of earnings based on the situation, usually hypothetical, of each possible action being taken. This takes into account situations such as stock options and convertible bonds that could mean an increase in the total number of shares. While diluted earnings per share is somewhat of a worst case scenario and not very relevant to the real world, it can be used to compare different companies on an equal footing.
Earnings per share is designed as a measure of how well a company is using the money invested in it when it went public. The precise method of calculating the figure varies, depending on accounting practices, but the general principle is that it is total earnings divided by the number of shares in the company. This makes it easier to assess a company’s performance in situations such as when a company has higher earnings than a rival, but also has many more shares, meaning the earnings are less valuable in terms of individual shares. In principle, earnings per share represents the dividend that the company would pay if it decided to distribute all of its earnings to shareholders, rather than retain any of it for future expenses.
This basic figure does not take into account that the total number of shares may change. This is due to various financial setups that can give people the right to take new shares in the future. This would increase the number of shares and thus dilute their individual value. These are taken into account when calculating diluted earnings per share.
There are several situations that can lead to stock dilution. One is the simple stock option where, more commonly, an employee can buy newly created shares at a fixed price if he chooses. Another is preferred stock, a hybrid between a standard stock investment and a debt security, such as a bond. Typically, a holder of preferred stock has the right to convert it into standard or common stock. There is a similar product known as a convertible bond, which the holder can exchange for shares if he wishes.
To account for this, two adjustments are generally made to the basic earnings per share calculation when calculating diluted earnings per share. The first is to remove dividends paid to preferred stock holders from the income figure; This is necessary to ensure the balance of the figures. The second is to increase the figure for the number of shares in the company to account for all options that could generate additional shares.
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