Diluted Earnings Per Share (Diluted EPS) Definition

Diluted EPS is a calculation used to gauge the quality of a company's earnings per share (EPS) if all convertible securities were exercised. Convertible securities are all outstanding convertible preferred shares, convertible debentures, stock options, and warrants. Unless a company has no additional potential shares outstanding (rare), the diluted EPS will always be lower than the simple or basic EPS.

$\begin{aligned} &\text{Diluted EPS} = \frac{ \textit{Net income} - \textit{preferred dividends} }{ \textit{Weighted average shares outstanding} + \textit{conversion of dilutive securities}} \\ &\textbf{where:}\\ &\textit{Dilutive securities}=\text{in-the-money options, warrants and other securities}\\ \end{aligned}$​Diluted EPS=Weighted average shares outstanding+conversion of dilutive securitiesNet income−preferred dividends​where:Dilutive securities=in-the-money options, warrants and other securities​

Diluted EPS considers what would happen if dilutive securities were exercised. Dilutive securities are securities that are not common stock but can be converted to common stock if the holder exercises that option. If converted, dilutive securities effectively increase the weighted number of shares outstanding, which decreases EPS.

Earnings per share, the value of earnings per share of outstanding common stock, is a very important measure to assess a company's financial health. When reporting financial results, revenue and EPS are the two most commonly assessed metrics. EPS is reported on a company's income statement, and only public companies are required to report it. In their earnings reports, companies report both primary and diluted EPS, but the focus is generally on the more conservative diluted EPS measure. Dilutive EPS is considered a conservative metric because it indicates a worst-case scenario in terms of EPS.

It is unlikely that everyone holding options, warrants, convertible preferred shares, etc. would convert their shares simultaneously. However, if things go well, there is a good chance that all options and convertibles will be converted into common stock. A large difference between a company's basic EPS and diluted EPS can indicate high potential dilution for the company's shares, an unappealing attribute according to most analysts and investors. For example, company A has $9 billion outstanding shares. There is a $0.10 difference between its basic EPS and diluted EPS. While $0.10 seems insignificant, it equates to $900 million in value not available to investors. 

Convertible preferred stock, stock options, and convertible bonds are common types of dilutive securities. Convertible preferred stock is a preferred share that can be converted to a common share at any time. Stock options, a common employee benefit, grant the buyer the right to purchase common stock at a set price at a set time. Convertible bonds are similar to convertible preferred stock as they are converted to common shares at the prices and times specified in their contracts. All of these securities, if exercised, would increase the number of shares outstanding and decrease EPS.