Companies with complex capital structures are required to present both basic and diluted earnings per share.

In computing diluted EPS, the potential impact (i.e., the assumed conversion) of potentially dilutive securities is considered in addition to the weighted average shares.

The impact of assumed conversion of potentially dilutive securities on EPS will be on both numerator and denominator of EPS computation.

To be included in the diluted EPS calculation, the potentially dilutive securities must have dilutive effect on EPS, that is, the assumed conversion of the potentially dilutive security has a negative impact on the EPS (i.e., reduce the EPS). These are dilutive securities and they decrease EPS if exercised or converted into common stock. If the impact is that the EPS increases, then they are called antidilutive securities.

There are four main securities:

• Convertible preferred stock
• Convertible bonds
• Stock options
• Warrants

These securities will impact both the numerator and denominator of the EPS. 

Stock options and warrants are dilutive if the exercise of the option results in an increase of common shares using a treasury stock method. We can also say that stock options and warrants are dilutive only when their exercise prices are less than the average market price of the stock over the year. If they are dilutive, they are the first to be included in the computation of Diluted EPS.

Example

Assume a corporation has 10,000 common shares and options to purchase 1,000 common shares at $20 per share outstanding for the entire year. The average market price for the common stock was $25 per share. The net increase in the denominator would be 200 computed as follow:

If the option is exercises, then the company will receive $20,000 and issue 1,000 shares. The treasury stock method assumes that the company uses this money to repurchase stocks at the average market price. The average market price is $25, So, the company will be able to purchase 20,000/25 = 800 shares. The net increase in common shares = 1,000 – 800 = 200.

Other potentially dilutive securities (i.e., convertible preferred stocks and convertible bonds) would be included in DEPS after stock options and warrants only if their inclusion has a dilutive effect on the EPS.