Diluted earnings per share is indicator that describes the quality of the earnings per share, otherwise known as EPS, of a company.
The diluted earnings per share requires the assumption that all dilutive potential common stocks are diluted. This figure is usually lower than the EPS. By determining the diluted EPS, one can get a picture of the worst possible scenario, that is, one in which all entities who did not purchase their stocks for the full value exercise their options. Investors usually see dilution as a negative indicator.
To compute for the EPS, divide profits by shares outstanding. The greater the number of shares outstanding, the smaller the earnings per share. This means that each shareholder gets less. Shares outstanding may include stock options and preferred shares, among others.
On the other hand, dilutive potential common stocks include convertible preferred shares, stock options, convertible debentures, share warrants, and other similar types of stock.
Once the EPS has been determined, each of the dilutive securities is used to dilute the original figure.
An investor who holds a diluted share makes less profit, because he only receives diluted earnings per share. Holders of diluted shares have less stockholders equity than if the shares were not diluted. Therefore, stockholders do not usually view diluted shares as attractive.
Banks may still make diluted shares available, however, in an attempt to acquire more capital. Companies may also issue additional stocks for the same purpose, thus diluting the existing shares.