Take Note of Your Diluted Earnings Per Share

Diluted earnings per share takes into account what would occur if all convertible securities in a company's stock were exercised. The metric starts with the same basic formula as earnings per share; the company's profit is divided by its total number of shares outstanding. However, diluted earnings per share also accounts for stock options, convertible preferred shares, convertible debentures and warrants outstanding on the company's stock. Essentially, the diluted earnings per share formula shows what would occur if every single one of these conversions was exercised all at once.

Significance of Diluted Earnings per Share

This factor provides a significant indication of a company's true potential profit to pass on to stock holders. It is not likely that absolutely no convertible securities will be converted in a given year. As a result, a straight earnings per share analysis will always provide a number that is much higher than the likely potential profit per investor. If you are counting your pennies based on earnings per share alone, you will be let down at year's end when you learn that the number of shares has actually increased due to conversions, and your piece of the pie just got a lot smaller.

Limitations of Diluted Earnings per Share

Just as it is unlikely that no conversions will be made in a given year, it is equally unlikely that all conversions will be exercised at once. This would only occur in a panic situation, but even then the probability all options would be exercised in nearly zero. As a result, using diluted earnings per share alone is not a sufficient model either. If you were to rely on this metric, you would be surprised with how different it is than your actual earnings at the end of a given year. In reality, only a small number of the potential conversions are exercised each year.

Using Diluted Earnings per Share Effectively

Since neither earnings per share nor diluted earnings per share is truly an efficient measure, analysts rely on a combination of the two. In specific, investors should favor those companies where diluted earnings per share and earnings per share are relatively close. In these scenarios, there are not many outstanding conversions that could be exercised. Even in a "worst case scenario," an individual investor's profit would not drop substantially.

On the other hand, a company that has a very large different in diluted earnings and earnings per share may pose a risk for investors. In this case, there is a high potential for dilution of the value of the stocks an investor holds. The investor would see the value of that stock shrink drastically if even a portion of the potential conversions are exercised. If more than 10 percent of the conversions were exercised on a stock, consider what would happen to the earnings per share. If this scenario shows significant loss in the value of the asset, an investor may consider letting go of the stock when the opportunity presents itself. It is not highly unlikely a 10 percent conversion would occur.

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