What is Earnings Per Share (EPS): Basic EPS vs. Diluted EPS and How To Calculate Them?

 Hello guys,

Continuing on to my CFA journey, today I have studied about the Earnings Per Share (EPS) concept as presented in the CFA curriculum. I would like to put the findings here for me as well as for all of you. This will make it easier to revise and review the concepts when we get back to this topic again. So, let me put all the concepts into this blog post.

What is Earnings Per Share (EPS)?

EPS measures the portion of a company’s profit allocated to each outstanding share of common stock. It's a key metric for investors to gauge corporate performance. Earnings Per Share (EPS) is a foundational concept for equity analysis and plays a key role in evaluating a company’s profitability.

CFA Relevance:

EPS shows up in multiple places across the CFA curriculum, especially in:

Financial Reporting & Analysis (FRA): For analyzing income statements and understanding earnings quality.

Equity Valuation: As input for models like the Price/Earnings (P/E) ratio.

Ethics: Where misleading EPS presentation can violate standards of fairness and transparency.

How do we calculate EPS? There are 02 (two) common variants of EPS, each having its own formula:

1. Basic EPS: Earnings allocated to currently outstanding common shares. Formula for Basic EPS is:

     2. Diluted EPS: Earnings allocated to all potential common shares, assuming conversion of dilutive instruments. Formula for Diluted EPS is:

To understand the difference between Basic EPS and Diluted EPS, I think it is imperative that we must know about the capital structure of a firm.

A company’s capital is composed of its equity and debt. Some types of equity have preference over others, and some debt (and other instruments) may be converted into equity.

When a company has issued any financial instruments that are potentially convertible into common stock, it is said to have a complex capital structure. Examples of financial instruments that are potentially convertible into common stock include convertible bonds, convertible preferred stock, employee stock options and warrants.

If a company’s capital structure does not include such potentially convertible financial instruments, it is said to have a simple capital structure.

The distinction between simple versus complex capital structure is relevant to the calculation of EPS because financial instruments that are potentially convertible into common stock could, as a result of conversion or exercise, potentially dilute (i.e. decrease) EPS. Information about such a potential dilution is valuable to a company’s current and potential shareholders; therefore, accounting standards require companies to disclose what their EPS would be if all dilutive financial instruments were converted into common stock. The EPS that would result if all dilutive financial instruments were converted is called diluted EPS. In contrast, basic EPS is calculated using the reported earnings available to common shareholders of the parent company and the weighted average number of shares outstanding.

Think of Basic EPS like measuring your current savings divided by your current bills. Diluted EPS is like considering future bills too—credit card balances, loans coming due—giving a more cautious view of your net position.

Why Two Versions?

Because Basic EPS might paint too rosy a picture. Companies with stock options or convertible debt have potential future dilution, and investors need visibility into this.

How does share repurchase affect Earnings Per Share (EPS)?

When a company repurchases its own shares, it reduces the number of shares outstanding in the market. Here's how that affects EPS:

EPS is calculated using the formula:

EPS = (Net Income - Preferred Dividends) / (Weighted Average Shares Outstanding)

🔄 Hence, a share repurchase influences EPS in the following ways:

• Fewer Shares Outstanding: By buying back shares, the denominator in the EPS formula becomes smaller.
• Higher EPS: With a smaller denominator and unchanged or improved net income, EPS typically increases.
• Market Perception: A rising EPS can make the company appear more profitable per share, often signaling confidence in future performance.

🧠 Example

Suppose a company earns $10 million in net income and has 5 million shares outstanding:

• Before buyback:
  EPS = {10,000,000}/{5,000,000} = 2.00
• After repurchasing 1 million shares:
  EPS = {10,000,000}/{4,000,000} = 2.50

➡️ EPS jumps by 25% without changing net income, making the stock more attractive to investors.

⚠️ Caution

• If funded through debt, buybacks may increase financial risk.
• A temporary EPS boost may mask deeper issues if net income isn't improving.

CONCEPTUAL QUESTIONS:

1. Which of the following scenarios requires calculating Diluted EPS instead of Basic EPS?

A - The company has issued only common stock.

B - The company has convertible bonds outstanding.

C - There are no stock options, warrants, or preferred shares.

D - The company reports net income without any potential share dilution.

2. Which statement best describes why Diluted EPS is more conservative than Basic EPS? 

A - It uses actual outstanding shares only.

B - It excludes preferred dividends.

C - It factors in potential dilution from securities.

D - It ignores earnings volatility.

3. Assume the following data:

Net income = $1,000,000

Preferred dividends = $50,000

Weighted average common shares = 500,000

Potential shares from stock options = 100,000

What is the Basic EPS and Diluted EPS?

A - Basic EPS = $2.00; Diluted EPS = $1.67

B - Basic EPS = $1.90; Diluted EPS = $1.67

C - Basic EPS = $1.90; Diluted EPS = $1.82

D - Basic EPS = $1.80; Diluted EPS = $1.7