Earnings Per Share (EPS) is one of the most widely used measures of a company’s performance. EPS tells us how much of earnings are attributable to each share that is available to common shareholders. Both IFRS and US GAAP require companies to report EPS on the face of the income statement (for net income and for income from continuing operations). In this article, I’ll explain how to calculate basic EPS and diluted EPS. We will work through all possible scenarios that can occur on CFA Level 1 exam.
Learning Objective
What is Earnings Per Share?
Earnings Per Share (EPS) represents a company’s profit allocated to each outstanding share of common stock. It is a vital metric for investors for two main reasons. First, it is the foundation for the Price-to-Earnings (P/E) ratio, a key metric used to determine how the market values a company. Second, by standardizing earnings on a per-share basis, EPS makes it easy to compare the profitability of different companies, regardless of their size.
The numerator, Net Income Available to Common Shareholders, represents the portion of net income that belongs to common stockholders. This is calculated by taking the company’s net income and subtracting any dividends owed to preferred shareholders, as they have a prior claim on earnings.
In this article, we’ll start by examining how to calculate Basic EPS for companies with a simple capital structure—that is, companies without any securities that could be converted into common stock. Afterward, we will explore how to account for potentially dilutive securities in companies with a complex capital structure and calculate the corresponding Diluted EPS.
Basic EPS Formula and Calculation
Basic EPS represents the earnings available to each existing common share, assuming no dilution. So we simply cannot have only Net Income from financial statement. We need to subtract Preferred Dividends (since preferred dividends are paid out before common shareholders receive anything).
The denominator uses the weighted average number of common shares outstanding because the number of shares can change throughout the year due to activities like share issuances, splits or buybacks. Weighting the shares by the time they were outstanding provides a more accurate representation of the earnings attributable to each share over the period.
In a simple scenario with no preferred stock, Basic EPS = Net Income ÷ Weighted Avg Shares.
For instance, if net income is $1,000,000 and there are 200,000 shares, basic EPS is $5.00. If the company also had preferred shares and paid $50,000 in preferred dividends, the earnings available to common would be $950,000, and basic EPS would be $4.75 ($950,000 ÷ 200,000).
A critical point to remember involves stock splits and stock dividends, which are treated differently from new share issuances. The key distinction is that stock splits and dividends do not raise new capital for the company. They simply increase the number of shares outstanding, effectively re-slicing the same economic pie into smaller pieces. To ensure that EPS figures remain comparable over time, these changes are applied retroactively. For example, if a company executes a 2-for-1 stock split, the calculation treats the split as if it happened on the very first day of the reporting period. This prevents the misleading impression that profitability has halved overnight.
In contrast, a new share issuance does raise capital, which the company can use to generate additional earnings. Since that capital was only available from the date of issuance, these new shares are time-weighted in the EPS calculation, not applied retroactively.
Basic EPS gives us a clear picture of earnings per share based on the shares that are currently in the market. However, this is not the full story for many companies. What happens if the company has a complex capital structure, with outstanding stock options, convertible bonds, or convertible preferred stock? These instruments, known as potentially dilutive securities, could be converted into common stock, thereby increasing the total number of shares and diluting the earnings for existing shareholders. To provide a more conservative and forward-looking view, we must calculate Diluted EPS. This metric answers the crucial question: “What would our EPS look like in a worst-case scenario where all dilutive securities are converted into common shares?”
Practice Exercise – Basic EPS
ABC Corporation reported $20 million in net income for 2024.
During the entire year the firm had 200 000 non-convertible preferred shares, each paying an annual dividend of $3.
Common-share activity in 2024 was as follows (all dates 2024):
| Date | Event | Change in Common Shares |
|---|---|---|
| 1 Jan | Shares outstanding | 5 000 |
| 1 Apr | Shares issued | +3 000 |
| 1 May | 2-for-1 stock split | – |
| 1 Aug | Shares repurchased | –2 000 |
| 1 Oct | Shares issued | +1 000 |
Calculating Basic EPS
Determine income available to common shareholders
Preferred dividends:
Income for common shares:
Compute the weighted-average common shares
Because of the 2-for-1 split on 1 May, restate all share amounts as if the split had occurred on 1 January (i.e., multiply pre-May figures by 2).
| Period | Months | Split-adjusted shares |
|---|---|---|
| Jan – Mar | 3 | |
| Apr | 1 | |
| May – Jul | 3 | 16 000 |
| Aug – Sep | 2 | (16 000 - 2 000 = 14 000) |
| Oct – Dec | 3 | (14 000 + 1 000 = 15 000) |
Weighted-average shares:
Basic EPS
Diluted EPS and Complex Capital Structures
When a company has a complex capital structure, it means there are securities out there (like convertible bonds, convertible preferred stock, stock options, or warrants) that can potentially turn into common shares. Diluted EPS is calculated under the assumption that ALL those dilutive securities are converted or exercised, increasing the total shares outstanding. Diluted EPS thus answers: “What would EPS be if all the things that could become common shares did become common shares (and thus ‘diluted’ the existing shareholders’ stake)?”
By definition, diluted EPS will always be less than or equal to basic EPS – additional shares in the denominator either reduce the per-share earnings or leave it unchanged (they can’t increase it). If calculating an assumed conversion leads to a higher EPS than basic, that security is actually anti-dilutive and is excluded from diluted EPS calculations. In other words, companies do not include any potential conversion that would make EPS go up. Only include those conversions that reduce (dilute) EPS.
Common types of potential common shares that can dilute EPS include:
- Convertible Preferred Stock – can be converted into common shares, replacing preferred dividends with new common shares.
- Convertible Bonds (Convertible Debt) – can be converted into common shares, replacing interest expense with new shares.
- Stock Options and Warrants – give the holder the right to buy common shares, increasing total shares when exercised.
For each category, a specific method is used in diluted EPS calculations:
-
If-Converted Method (for convertibles): Assume the convertible preferred shares or bonds were converted at the beginning of the period. This means:
- For convertible preferred: add back preferred dividends to the numerator (since those wouldn’t be paid if the shares had converted to common), and add the new common shares from conversion to the denominator.
- For convertible debt: add back after-tax interest expense to the numerator (since interest would not be paid if debt converted). Also add the new shares from the bond conversion to the denominator.
-
Treasury Stock Method (for options and warrants): Assume all in-the-money options/warrants are exercised at the beginning of the period, and the company uses the proceeds from exercise to repurchase as many shares as possible at the average market price of the stock during the period.
- The net effect is an increase in the share count equal to the number of shares issued from option exercise minus the number of shares repurchased with the cash proceeds.
- There is no impact on the numerator for options/warrants because exercising options doesn’t affect net income (no interest or dividend is saved). Only the denominator increases.
- If the exercise price is higher than the average market price, the options are not dilutive (because exercising would actually be unfavorable – these would be left unexercised in reality, and by convention are excluded from diluted EPS).
The formula for Diluted EPS using the Treasury Stock method adjusts the share count in the denominator, while the numerator (earnings) remains unaffected.
Let’s summarize: Basic EPS uses actual earnings and shares. Diluted EPS adjusts both earnings and shares for hypothetical conversions:
- Add back any earnings that would be saved (interest net of tax, or preferred dividends) to the numerator.
- Add all additional common shares that would be created by conversions/options to the denominator.
- Exclude any conversion or option that increases EPS (anti-dilutive).
Now, let’s apply these concepts in last example.
Example: Calculating Diluted EPS
Suppose we have a fictional company, Alpha Co., with the following capital structure and earnings for the year:
- Net Income = $1,000,000
- Preferred stock: None (no preferred dividends)
- Common stock: 200,000 shares outstanding (no change during the year)
- Convertible bonds: $2,000,000 of 5% convertible bonds outstanding. They are convertible into a total of 20,000 common shares.
- Tax Rate: 30%
- Stock options: 10,000 employee stock options outstanding, with an exercise price of $20. The average market price of Alpha’s stock during the year was $50.
We will calculate Alpha’s basic EPS and diluted EPS step by step.
Solving EPS Calculation with a Complex Capital Structure
Break down the information:
- Net income: $1,000,000 (all attributable to common since no preferred dividends).
- Weighted-average common shares: 200,000.
- Convertible bonds: $2,000,000 face value at 5% interest = $100,000 annual interest expense. If converted, these bonds would turn into 20,000 new common shares.
- Tax rate: 30% (needed to determine the after-tax interest savings).
- Stock options: 10,000 options exercisable at $20. Proceeds if exercised = $20 × 10,000 = $200,000. Average market price = $50, so those proceeds could buy back $200,000/$50 = 4,000 shares. If exercised, the net new shares = 10,000 issued – 4,000 repurchased = 6,000 additional shares.
Calculate Basic EPS first.
Since there are no preferred dividends, basic EPS is simply net income divided by the weighted average shares outstanding.
Adjust for the convertible bonds (if-converted method).
If the bonds had converted at the start of the year, Alpha Co. would not have paid the $100,000 in interest. That savings would flow into earnings available to shareholders. However, we must consider taxes: the interest is tax-deductible, so not paying interest would increase net income by the after-tax amount of the interest.
- After-tax interest saved = $100,000 × (1 – 0.30) = $70,000.
Also, conversion would add 20,000 common shares to the denominator.
Now recalculate EPS under this conversion assumption:
- Adjusted numerator = $1,000,000 + $70,000 = $1,070,000 (adding back after-tax interest).
- Adjusted denominator = 200,000 + 20,000 = 220,000 shares.
Compare this $4.86 to the original $5.00 basic EPS. EPS decreased, which means the conversion is dilutive (makes EPS lower). We will include the convertible bonds in diluted EPS.
(If the EPS had increased or stayed above $5.00, the bonds would be anti-dilutive and we would exclude them.)
Adjust for the stock options (treasury stock method).
Now assume all 10,000 options were exercised. This would bring in $200,000 of cash to the company (10,000 × $20). With the stock at $50 average price, the company could buy back 4,000 shares with that cash.
So, out of the 10,000 new shares issued to option holders, the net increase in shares is 6,000 (the company effectively issues 6,000 additional shares without a net earnings impact).
The numerator is not affected by options (no interest or dividends involved).
Add these net shares to the denominator and compute EPS:
- Adjusted numerator = $1,070,000 (same as after bond conversion; options don’t change earnings).
- Adjusted denominator = 220,000 + 6,000 = 226,000 shares.
This is our Diluted EPS for Alpha Co. Given the assumptions, diluted EPS ≈ $4.73, compared to the basic EPS of $5.00.
Summary of results:
- Basic EPS = $5.00
- Diluted EPS (including all dilutive conversions) ≈ $4.73
We included both the convertible bonds and the options because each caused a drop in EPS. Had any security caused EPS to rise when assumed converted (for example, if the conversion of debt resulted in EPS above $5.00), we would leave it out of the diluted EPS calculation.
Wrapping Up
EPS is a fundamental measure of profitability that you, as a CFA Level I candidate, must master. Basic EPS gives a snapshot of earnings per share under the current capital structure, while diluted EPS paints a more conservative picture by accounting for all the ways the company’s share count could increase.
Always remember to adjust the numerator for any earnings that would be saved upon conversion (net of tax), adjust the denominator for additional shares, and exclude any antidilutive instruments.
See you in the next topic!