Diluted EPS – Advanced

Let’s take a closer look at Potential Ordinary Shares (POSs)—the key players in the Diluted EPS story. POSs are financial instruments that can be converted into ordinary shares. They include things like:

– Convertible Bonds: Debt instruments convertible into shares.

– Stock Options: Rights given to employees or investors to buy shares at a pre-defined price.

– Contingently Issuable Shares: Shares issued only if specific conditions (e.g., profit targets) are met.

These POSs affect two things in the EPS calculation:

1. Numerator (Profit): Changes like saving interest on convertible bonds are added back to the profit.

2. Denominator (Shares): The number of outstanding shares increases, which lowers the EPS.

The goal of Diluted EPS is not to complicate things but to make financial reporting more honest and transparent. It answers critical questions:

– What happens to earnings per share if every POS converts to a share?

– Are we painting an accurate picture of the company’s performance?

For example, imagine a company issuing convertible bonds to fund a major expansion. The Diluted EPS calculation ensures investors understand how those bonds might impact their returns.

Step 1: Identifying Potential Ordinary Shares (POSs)

Start by identifying every type of POS that could convert into shares during the reporting period.

For instance, let’s say a company has:

– 2 million convertible bonds.

– 1 million stock options.
Even if some of these POSs expire midway through the year, they must still be included in the calculation for the time they were active.

Step 2: Determining Earnings Per Incremental Share (EPIS)

EPIS calculates the impact of each POS on the company’s earnings. Here’s how it works:

Formula:
EPIS = Consequential Profit Impact ÷ Weighted-Average POSs

– Numerator Adjustments: Add back interest saved from convertible bonds or subtract costs like profit-sharing expenses.

– Denominator Adjustments: Add POSs to the outstanding shares, adjusting for time and cancellations.

For example:
A company saves ₹50 crore in interest (after tax) on convertible bonds, which convert into 5 crore shares. The EPIS for these bonds would be ₹50 crore ÷ 5 crore = ₹10.

Step 3: Ranking POSs by EPIS

Once EPIS is calculated for all POSs, rank them from the most dilutive (lowest EPIS) to the least dilutive.

For instance:

– Stock Options (EPIS = ₹5)

– Convertible Bonds (EPIS = ₹10)
The ranking ensures that the most impactful instruments are included first in the Diluted EPS calculation.

Step 4: Determining Basic EPS from Continuing Operations

The control number for Diluted EPS is the Basic EPS calculated from profit generated by continuing operations.

For example:

– Profit = ₹100 crore

– Weighted-Average Shares = 10 crore
Basic EPS = ₹100 crore ÷ 10 crore = ₹10.

Step 5: Calculating Diluted EPS and Identifying Dilutive POSs

Finally, combine the adjustments from the earlier steps to calculate Diluted EPS:

1. Add the first ranked POS (e.g., stock options):
Adjusted Shares = 10 crore + 1 crore (stock options).
Adjusted EPS = ₹100 crore ÷ 11 crore = ₹9.09.

2. Add the next POS (e.g., convertible bonds):
Adjusted Shares = 11 crore + 2 crore (convertible bonds).
Adjusted EPS = ₹100 crore ÷ 13 crore = ₹7.69.

This sequence continues until EPS stops decreasing.

Special Considerations in Diluted EPS

Certain complexities can arise during calculations. Here are some key considerations:

1. Instruments with Multiple Conversion Bases

If a POS offers multiple settlement options, like cash or shares, assume the option most favorable to the POS holder (usually shares).

2. Treasury Share Method for Options

This method adjusts for the impact of stock options by assuming proceeds are used to repurchase shares:

– Exercise 10,000 options at ₹50 = ₹5,00,000.

– Market price = ₹100/share.

– Shares repurchased = ₹5,00,000 ÷ ₹100 = 5,000 shares.

– Net increase in shares = 10,000 – 5,000 = 5,000 shares.

Practical Example of Diluted EPS Calculation

Let’s break down a full example:

Scenario:

– Net Profit = ₹200 crore

– Basic Shares = 10 crore

– POSs = 1 crore options (EPIS = ₹2) and 2 crore convertible bonds (EPIS = ₹5).

Step-by-Step Calculation:

1. Basic EPS = ₹200 crore ÷ 10 crore = ₹20.

2. Add stock options:

• Adjusted Shares = 10 crore + 1 crore = 11 crore.
• Adjusted EPS = ₹200 crore ÷ 11 crore = ₹18.18.

3. Add convertible bonds:

• Adjusted Shares = 11 crore + 2 crore = 13 crore.
• Adjusted EPS = ₹200 crore ÷ 13 crore = ₹15.38.

Final Diluted EPS = ₹15.38.

Comparative Analysis: Diluted EPS Across Industries

Diluted EPS is not a one-size-fits-all metric; its importance and impact vary significantly depending on the industry. Why? Because different sectors rely on unique financial structures and instruments, which dictate the extent of dilution.

Tech Sector: High Dilution from Stock-Based Compensation

In the tech world, companies, particularly startups, often use stock-based compensation to attract and retain top talent. Think of giants like Google, Apple, or young startups in the Silicon Valley ecosystem. They hand out stock options like candy to incentivize employees. While this is great for the workforce, it results in significant dilution for shareholders.

Finance Sector: Convertible Bonds Drive Dilution

The finance industry, including banks and NBFCs, frequently issues convertible bonds as a way to raise funds. Unlike tech companies, which use stock options, financial firms rely on convertible instruments. These bonds offer the dual advantage of raising debt capital with the flexibility to convert into equity.

Manufacturing Sector: Minimal Dilution

The manufacturing sector, in contrast, exhibits far less dilution. Companies in this space usually rely on traditional debt financing rather than convertible instruments or stock options. As a result, the gap between Basic EPS and Diluted EPS is typically minimal, offering a more stable view of earnings for shareholders.

Key Takeaway:

Understanding how Diluted EPS varies across industries is crucial. While a significant difference between Basic and Diluted EPS might raise alarms in the tech sector, it could be entirely normal in the finance world. This comparative lens helps investors tailor their analysis based on the industry they’re evaluating.

Advanced Metrics Derived from Diluted EPS

Diluted EPS on its own is a powerful metric, but it also serves as the foundation for advanced financial insights. Let’s explore a couple of metrics that take Diluted EPS analysis to the next level.

1. Dilution Ratio: Measuring the Extent of Dilution

The Dilution Ratio quantifies how much earnings per share are reduced due to dilution.

Formula:
Dilution Ratio = (Basic EPS – Diluted EPS) ÷ Basic EPS

Example:

– A company has a Basic EPS of ₹10 and a Diluted EPS of ₹8.

– Dilution Ratio = (₹10 – ₹8) ÷ ₹10 = 20%

This means earnings per share drop by 20% when all potential shares are considered. Investors use this metric to assess the severity of dilution and its impact on their returns.

2. Earnings Leverage Analysis: Assessing Growth Potential Under Dilution

Dilution doesn’t just impact current earnings—it also affects a company’s ability to grow EPS in the future. High dilution can constrain earnings growth because profits are spread across a larger pool of shares.

Conclusion

Diluted EPS goes beyond being a simple metric; it’s a window into a company’s financial reality under potential dilution scenarios. From understanding its foundations to exploring its role in advanced metrics, valuation, and corporate strategy, Diluted EPS equips investors and companies with invaluable insights.