Diluted Earnings per Share Formula

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Diluted Earnings per Share Formula

The Diluted Earnings per Share Formula

Diluted earnings per share is the amount of earnings for a reporting period that are available to each share of common stock outstanding during that reporting period, and to each share that would have been outstanding, assuming that common shares had been issued for all dilutive potential common stock outstanding during the period. An entity having more than common stock in its capital structure must present both basic and diluted earnings per share information for income from continuing operations and for net income. This information should appear on the face of the income statement.

The calculation of diluted earnings per share goes beyond the calculation of basic earnings per share to also include the effects of all dilutive potential common shares. As a result, you increase the number of shares outstanding by the weighted average number of additional common shares that would have been outstanding if all dilutive potential common stock had been converted to common stock. This dilutive change may also impact the profit or loss in the numerator of the earnings per share calculation. You calculate diluted earnings per share as follows:

Profit or loss attributable to common equity holders of the parent entity + Convertible preferred dividends + After-tax interest on convertible debt

Weighted average number of common shares outstanding during the period, plus all dilutive potential common stock

This calculation is further split into the profit or loss from continuing operations attributable to the parent entity, and total profit or loss attributable to the parent entity.

Adjustments to the Diluted Earnings per Share Formula

The following two adjustments are key changes to the numerator of the calculation of diluted earnings per share:

Dividends. Adjust for the after-tax effect of dividends or other dilutive potential common shares.
Interest expense. Reverse any interest expense related to dilutive potential common stock, since these shares are assumed to have been converted to common stock, which eliminates the interest expense.

Also incorporate the following adjustments into the denominator of the calculation of diluted earnings per share; these adjustments are in addition to those already noted for basic earnings per share:

Anti-dilutive shares. Do not include in the calculation of diluted earnings per share any contingent stock issuances that would have an anti-dilutive effect on earnings per share. This situation arises when an entity has a loss, since the inclusion of dilutive shares in the earnings per share equation would then reduce the amount of the loss per share.
Contingent shares, general. Treat contingently issuable common stock as outstanding as of the beginning of the period, and therefore included in the calculation of diluted earnings per share, as long as the conditions required to issue the shares have been satisfied.
Contingent shares. If a contingent share issuance depends on the future market price of common shares, then include the shares in the diluted earnings per share calculation, based on the current market price at the end of the period, if the effect is dilutive. If there is also a substantive non-market contingency feature, then do not include the shares in the diluted earnings per share calculation until the non-market contingency has been met.

If a share issuance is contingent upon satisfying certain conditions, and those conditions were satisfied by the end of the period, then include them in the diluted earnings per share calculation as of the beginning of the period. If the conditions were not satisfied by the end of the period, then include in the diluted earnings per share calculation, as of the beginning of the period, the number of shares (if any) that would be issuable if the end of the reporting period were the end of the contingency period, and if the result were dilutive.

If a contingent share payment is based on a specific amount of earnings and those earnings were attained in the period, then include the contingent shares in the diluted earnings per share calculation, if the result is dilutive.

Contracts settled in cash or shares. If a contract can be settled in either common stock or cash, assume that it will be settled in common stock if the effect is dilutive.
Convertible instruments. Include the dilutive effect of convertible instruments in diluted earnings per share when they are dilutive. Convertible preferred stock is anti-dilutive when the dividend on converted shares exceeds basic earnings per share. Convertible debt is anti-dilutive when the interest expense on its converted shares exceeds basic earnings per share. See the following example for Paulson Printing.
Dilutive shares. Add to the denominator the weighted average number of common stock that the entity would issue if all dilutive potential common stock were converted. In the absence of other information, these additional shares are assumed to have been issued at the beginning of the reporting period.
Exercise price. When calculating the number of potential shares, do so based on the most advantageous conversion rate from the perspective of the security holder.
Forward purchase contracts. If a contract requires the entity to repurchase its own shares, and the settlement price is higher than the average market price during the period, and the effect is dilutive, then include them in the diluted earnings per share calculation. For this calculation, assume that enough stock is issued at the beginning of the period to raise the proceeds to settle the contract, and that the proceeds are used to buy back the required number of shares, and that the difference between these two amounts is included in the diluted earnings per share calculation.
Multiple conversion rates. If there are multiple bases of conversion of dilutive potential common shares, then use the most advantageous conversion rate from the perspective of the holder.
Options and warrants. Assume that all dilutive options and warrants are exercised at their exercise price, then convert the proceeds into the number of shares that would have been purchased at the average market price during the period. The incremental shares resulting from these transactions is the difference between the number of shares assumed to be issued and the number of shares assumed to be purchased.

If dilutive options or warrants are issued or cancelled during a reporting period, include them in the diluted earnings per share calculation for that period.

There is only a dilutive effect when this average market price is greater than the exercise price of the options or warrants.

Purchased options. Only include purchased put options in the diluted earnings per share calculation if the exercise price is higher than the average market price during the period, and only include the effects of a purchased call option if the exercise price is lower than the market price. All other scenarios with such options are anti-dilutive, and so should not be included.
Share-based compensation. If employees are awarded non-vested shares or share options as part of share-based compensation plans, treat them as options for the purposes of calculating diluted earnings per share. Consider these awards to be outstanding as of the grant date, even if they cannot be exercised until a later vesting date.

You should determine the number of dilutive potential common shares independently for each period presented. Also, do not alter the earnings per share reported for previous periods to reflect changes in the price of common shares that might otherwise alter the number of options or warrants exercised.

Example of Diluted Earnings per Share

Paulson Printing earns a net profit of $1 million, and it has 10 million common shares outstanding. In addition, there is a $2 million convertible loan that has a six percent interest rate. The loan potentially converts to 3,000,000 of Paulson’s common shares. Paulson’s incremental tax rate is 35 percent.

Paulson’s basic earnings per share is $1 million ÷ 10 million shares, or $0.10/share. The following calculation shows the compilation of its diluted earnings per share:

Net profit	$1,000,000
+ Interest saved on $2,000,000 debt at 6%	120,000
- Reduced tax savings on foregone interest expense	(42,000)
Adjusted net earnings	$1,078,000

Common shares outstanding	10,000,000
+ Potential converted shares	3,000,000
Adjusted shares outstanding	13,000,000

Diluted earnings per share ($1,078,000 ÷ 13,000,000)	$0.08/share