Basic Earnings Per Share

Basic earnings per share is a rough measurement of the amount of a company's profit that can be allocated to one share of its stock. Basic earnings per share does not factor in the dilutive effects of convertible securities. Basic EPS is calculated as follows:

Basic EPS = (Net income – Preferred dividends) / Weighted average number of common shares outstanding

Basic earnings per share for companies that have a complex capital structure -- that is, they have issued potentially dilutive securities, then diluted EPS is considered to be a more precise metric than basic EPS. Diluted EPS takes into account all of the outstanding dilutive securities that could potentially be exercised (such as stock options and convertible preferred stock) and shows how such an action would affect earnings per share.

If a company has a simple capital structure, meaning that it has not issued any potentially dilutive securities, then basic EPS can be a useful metric on its own. Companies with a complex capital structure must report both basic EPS and diluted EPS to provide a more accurate picture of their earnings per share. Basic EPS will always be the higher of the two. If the company has a simple capital structure, it only needs to report basic EPS.

A company reports net income of $100 million after expenses and taxes. The company issues preferred dividends to its preferred stockholders of $23 million, leaving earnings available to common shareholders of $77 million. The company had 100 million common shares outstanding at the beginning of the year and issued 20 million new common shares in the second half of the year. As a result, the weighted average number of common shares outstanding is 110 million: 100 million shares for the first half of the year and 120 million shares for the second half of the year (100 x 0.5) + (120 x 0.5) = 110. Dividing the earnings available to common shareholders of $77 million by the weighted average number of common shares outstanding of 110 million gives a basic EPS of $0.70.

Stocks trade on multiples of earnings per share, so a rise in basic EPS can cause a stock's price to appreciate in line with the company's increasing earnings on a per share basis. Increasing basic EPS, however, does not mean the company is generating greater earnings on a gross basis. Companies can repurchase shares, decreasing their share count as a result and spread net income less preferred dividends over fewer common shares. Basic EPS could increase even if absolute earnings decrease with a falling common share count. Another consideration for basic EPS is its deviation from diluted EPS. If the two EPS measures are increasingly different, it may show that there is a high potential for current common shareholders to be diluted in the future.