Lesson 6 of 10
Reading earnings per share
Why there is no good level of earnings per share, what separates the basic figure from the diluted one, and how the number grows without the business growing.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- There is no good level of earnings per share: it is profit divided by a share count, and the count moves.
- For a convertible bond (A bond the holder can swap for a fixed number of shares.), diluted earnings per share changes the numerator too, not only the share count.
- An instrument is added only if it lowers the figure, so diluted is never higher than basic, and a loss year excludes all of them.
No level of earnings per share is good on its own. It is the year's profit divided by the number of shares, so the figure moves whenever the share count does. The diluted figure, the one most quoted, also counts shares that options and convertible bonds could still create.
One year of profit, three per-share figures
- Basic · 100 ÷ 100$1.00
- Add employee options · treasury stock method, 100 ÷ 102$0.98
- Add convertible debt · if-converted method, 122.50 ÷ 127$0.96
Basic, and the weighted average trap
Basic EPS equals Net income available to common shareholders divided by Weighted average common shares outstanding.
Example$100 ÷ 100 = $1.00
Both halves of that fraction hide something. Preferred dividends come out of the numerator first, and where a company carries more than one class of stock, profit is split between them before any division happens. The denominator is an average across the period, not a count on the last day. So a buyback finished in December barely moves that year's figure and moves next year's a great deal.
Diluted: options and convertibles
Options: treasury stock method
- Assume they are exercised.
- The cash buys back shares at the average price.
- Only the net new shares are added.
Ten options struck at 20 raise 200, which buys 8 shares at 25: 2 shares join the count.
Convertible bond: if-converted
- Assume it converted on day one.
- All its shares are added.
- The after-tax interest it no longer costs is added to profit.
The bond converts into 25 shares. It costs 30 of interest at a 6 percent coupon, 22.50 after a 25 percent tax. Add 22.50 to profit and 25 to the count: 122.50 ÷ 127 is 0.96.
Options change only the count. A convertible changes both halves.
Because 0.96 is below 0.98, the bond is dilutive and stays in.
Why diluted is never higher than basic
An instrument joins the diluted count only if it lowers earnings per share. In a loss year the same rule excludes everything: adding shares to a loss makes the loss per share smaller, so every option and convertible becomes antidilutive and is dropped. A diluted share count that falls in a bad year is usually this mechanism, not evidence that anyone bought back stock. Read it beside the actual count in the statement of shareholders equity before concluding anything from it.
Do it on a real 10-K
- Open the earnings per share note in Item 8.
- Divide the numerator by the basic count and check the basic figure.
- Read how many potential shares were excluded as antidilutive.
The number moves without the business moving
One year is a snapshot, not a trend
Graham's argument in chapter 12 of The Intelligent Investor is that reported per-share earnings are shaped by special charges, tax treatment and depreciation choices. Several years averaged carry more information than one year reported. Nothing about the mechanics above has changed that: the bottom line is the subtotal most exposed to a disposal, an impairment or a tax settlement. Every one of them arrives at full weight.
Check yourself
Diluted earnings per share is always what, compared with basic?
- Higher
- The same
- Never higher
Show the answer
Answer: C.
An instrument is added to the diluted count only if it lowers the figure, so diluted can only be lower than or equal to basic.A company reports a loss for the year. What happens to its diluted share count?
- It rises to include every convertible instrument
- It falls back to the basic count
- It is left blank on the statement
Show the answer
Answer: B.
Adding shares to a negative numerator would shrink the loss per share, so every option and convertible becomes antidilutive and diluted equals basic.A company's profit is flat for two years but it buys back shares. What happens to earnings per share?
- It stays flat too
- It rises, with nothing else different
- It falls, because there are fewer owners to divide among
Show the answer
Answer: B.
Earnings per share is profit divided by a shrinking share count, so it can rise on a buyback alone while the business is unchanged.Sources
- Graham, The Intelligent Investor, revised edition 1973, chapter 12: per-share earnings shaped by special charges, tax treatment and depreciation choices.
What this leaves out
- This lesson does not say what level of earnings per share, or of its growth, is acceptable for any company. The figure means something only next to a price, a capital base or a history.
- The antidilution test runs on income from continuing operations, not on net income.
- The mechanics above are the common cases. Participating securities, multiple classes of common stock and instruments settled at the company's option each follow further rules that change the number.
- The worked examples use round invented numbers so the arithmetic can be checked by hand. Nothing here is advice about any security.