If a company has a simple capital structure (in other words, one that includes no potentially dilutive financial instruments), then its basic EPS is equal to its diluted EPS. However, if a company has potentially dilutive financial instruments, its diluted EPS may differ from its basic EPS. Diluted EPS, by definition, is always equal to or less than basic EPS. The sections below describe the effects of three types of potentially dilutive financial instruments on diluted EPS: convertible preferred, convertible debt, and employee stock options. The final section explains why not all potentially dilutive financial instruments actually result in a difference between basic and diluted EPS.
When a company has convertible preferred stock outstanding, diluted EPS is calculated using the if-converted method. The if-converted method is based on what EPS would have been if the convertible preferred securities had been converted at the beginning of the period. In other words, the method calculates what the effect would have been if the convertible preferred shares converted at the beginning of the period. If the convertible shares had been converted, there would be two effects. First, the convertible preferred securities would no longer be outstanding; instead, additional common stock would be outstanding. Thus, under the if-converted method, the weighted average number of shares outstanding would be higher than in the basic EPS calculation. Second, if such a conversion had taken place, the company would not have paid preferred dividends. Thus, under the if-converted method, the net income available to common shareholders would be higher than in the basic EPS calculation.
Diluted EPS using the if-converted method for convertible preferred stock is equal to net income divided by the weighted average number of shares outstanding from the basic EPS calculation plus the additional shares of common stock that would be issued upon conversion of the preferred. Thus, the formula to calculate diluted EPS using the if-converted method for preferred stock is:
(Weighted average number of shares outstanding + New common shares that would have been issued at conversion)
A diluted EPS calculation using the if-converted method for preferred stock is provided in Example 15.
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