While analyzing a particular stock for investment, we come across Basic EPS and Diluted EPS. Often investors would get confused about these terminologies. Stock brokers who recommend stocks would further confuse by comparing wrong EPS indicating this stock is available at lower share prices. What is Basic Earnings per Share (EPS)? What is Diluted Earnings Per Share (EPS)? How should you interpret these two EPS’s while investing in a particular stock?
What is Basic EPS (Earnings per Share)?
Basic EPS is that portion of the company’s profit that is allocated to each outstanding share of common stock. It serves as an indicator to the company’s profit. EPS is a beneficial measure for companies with basic capital structures. Company having only common stock in its capital structure presents only its basic EPS for profits from current operations and net profit. It indicates the profit earned by the company over a certain period of time. The formulae to calculate basic EPS is as under
Basic EPS = (net Profit – preferred dividends) / weighted average number of common shares outstanding.
What is Diluted EPS (Earnings Per Share)?
Diluted earnings per share is a profitability calculation which shows the amount of net profit each share will receive if all of the dilutive securities like stock options, convertible preferred stock and bond, purchase of common stocks are realized. Diluted EPS is more comprehensive than basic EPS as it shows value based on the earning per share. The formulae to calculate diluted EPS is as under.
Diluted EPS = total Profit – preferred dividends / outstanding shares + diluted shares)
When an investor should use Dilute EPS?
Diluted earnings per share help the investors to determine the earnings of the company if many of convertible instruments are converted to common stock. This represents the worst scenario of EPS. A public based businesses reports the information of EPS only. Basic EPS will only reflect the shares currently outstanding and but not the probable dilution from convertibles, options, warrants, etc. The diluted EPS results in more outstanding shares. As a result, the basic EPS will always be higher than diluted EPS. To calculate basic EPS remove the effects of outstanding securities.
Let me explain these with some examples.
Company ABC had Rs 200,000,000 in net profit applicable to common shares for accounting year and it had 30,000,000 outstanding shares in the beginning of the year and 15,000,000 shares outstanding at the end of the year then the Basic EPS would be Rs 200,000,000 ÷ ([30,000,000 + 15,000,000] ÷ 2), or Rs 8.88. If ABC had 5,000,000 shares of stock that could be convertible at a price lower than the current market price, then ABC Diluted EPS would be 200,000,000 ÷ ([[30,000,000 + 15,000,000]+5,000,000] ÷ 2) or 7.27.
Similarly if suppose company XYZ had Rs 150,000,000 in net profit applicable to common shares for accounting and 50,000,000 outstanding shares at the beginning and 25,000,000 shares outstanding at the end of the year then basic EPS would have been 150,000,000/ ([50,0000,00 + 25,000,000] /2)] or Rs 4. If XYZ had 7,000,000 shares of convertible stock the XYZ diluted EPS would be 150,000,000/([50,000,000 + 25,000,000] + 7,000,000] /2) or 3.37.
What Financial Ratios are computed using Basic EPS and Diluted EPS?
Earnings are the most important factor that reflects the financial health of the company. EPS reflects the true status of the company to its investors. Ratio analysis is the most important method used by investors for decision making. EPS forms the basis of many financial ratios. These are used for different types of analysis like:
Price to Earnings ratio (P/E Ratio)
It shows the amount of stock investors paying for each rupee of earnings. It shows if the market is misconstruing the company. It helps the investors to know the time taken by the company's basic EPS to pay back investment cost. The P/E ratio can be reversed to calculate the earnings yield. You can select multibagger stocks with P/E Ratio.
The price-to-earnings growth ratio, or PEG ratio, is the revised form of P/E ratio that takes basic EPS and then calculates the P/E ratio with an adjustment of earnings per share in future. It helps to analyze the price of stock and EPS of the company. It signifies the correct value of the stock.
Also Read: Top Blue Chip Stocks to invest in India now
Dividend-Adjusted PEG Ratio
It is more revised form of PEG ratio that takes the basic EPS and then takes into account the future growth of the company and also the dividend yield. It is dividend per share divided by price of per share. Presuming out the type of EPS analysis used to pay for a company can be tricky. Financial ratio analysis helps in evaluating factors such as profitability, risk, taxes but also studying on economics inflation, management quality and industry outlook are important factors to be considered while investing in a stock.
Conclusion: Many investors really have no idea about how to select a company from the investment point of view. Basic EPS and Diluted EPS computations would help in understanding Earnings per Share which can in turn help you to understand how strong a company is for long term investment.
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Basic EPS Vs Diluted EPS – Which one should you prefer while investing