The P/E multiple or the Price / Earning ratio is probably cited more than any other when it comes to financial numbers.
The EPS (Earnings Per Share) is one of two inputs of the P/E ratio and companies have to report two types of EPS numbers – Basic EPS and Diluted EPS.
Basic EPS is calculated by taking the total net profit and dividing it by the total number of ordinary shares that are outstanding for the company.
If the total number of shares were increased then the profit per shareholder would reduce and that’s primarily what happens in the case of diluted EPS.
Diluted EPS is calculated by assuming that everyone who has an instrument that can be converted into an equity share converts it into an equity share and so the total number of outstanding shares of the company increase, thereby reducing the EPS.
Stock options are one example of these kind of instruments, preferred stock is another, and in the case of many Indian companies – FCCBs (Foreign Currency Convertible Bonds) feature prominently among instruments that can dilute the earnings. Subject to certain terms, all these instruments can be converted to ordinary shares by the instrument holders and if they did that then the profit available to each shareholder will be reduced and earnings will be diluted.
Now just because an instrument can be converted into a share doesn’t mean that it will be converted and that will be true in a lot of cases where the dilution occurs due to preferred stock or FCCBs.
The other aspect of this is that when you convert such instruments to ordinary shares the company is relieved of the obligations that arise due to them. So, if FCCBs were converted to shares then the company no longer needs to pay any interest on them and if the preference shares were to be converted to ordinary shares then they won’t have to pay dividends on that any longer, so that will actually increase the profit available to shareholders and that’s why the net profit that’s used to calculated the Basic EPS and Diluted EPS is different.
Although not exactly diluted EPS, one thing that comes to mind while talking about this subject is when companies do an IPO – they often sell promoter stock and issue new shares as well.
The EPS and PE ratios that are normally reported in the papers and present in the prospectus are the ones that are calculated before the new shares are issued. But that is a bit inaccurate because as soon as the IPO hits the market, the new shares will be issued and the earnings will be diluted to that extent. I have an extensive post on that with the specific example of Power Grid FPO and that will make a good further subject and also give some context on how the dilution actually works with some concrete numbers.
As always, questions and comments welcome!
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