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Monday, March 21, 2011

How to calculate diluted earnings per share

Stock dilution refers to loss of common share value caused by an increase in the number of units of a company's equity ownership. As more stock become available to shareholders and potential shareholders, each share of ownership holds a smaller piece of the company via dilution. Dilution occurs because the total amount of available wealth becomes distributed over a wider number of shares. Just as whiskey becomes less concentrated when water is added, so too does wealth when ownership is added.


Stock dilution can be measured in several ways. One such measure of stock dilution is diluted earnings per share that is calculated by dividing profit by all shares that are classified as, and could be classified as common shares. Another method of measuring stock dilution is by dividing the total market capitalization after a new stock offering by total outstanding shares. Market capitalization is the total number of shares outstanding multiplied by the number of shares.

Method 1: Diluted Earnings Per Share (DEPS)
DEPS= Gross Profit / Common shares + potential common shares
Ex. $10,000 / 1000 + 100 convertible shares
=$ 10,000/ 1,100 = $9.09

• Dilution via share conversion causes a .91 cent adjustment in share value.

Method 2: Capitalized value per share (CVPS)
CVPS= Total common stock x price per share + new capital/ Total Shares
= Market capitalization + New Capital/ Total shares
Ex. 1,000 x $10.00 + $1000 / 1100
= $11,000 / 1,100 =$10.00

• Calculation does not lead to diluted value using exact same numbers as method 1.

It is evident from the above two methods, new shares can be framed to demonstrate dilution or no dilution depending on whether profit or capital is used in the formula. For investors, the better of the two methods of calculation would be method one because it is profit that is distributed to shareholders not investment capital.

The advantage of increasing the number of shareholders is an increase in capital available to a company. For example, suppose ABC Company seeks to initiate a new project that is estimated to yield 10% return on Investment. To raise the capital to embark on the project ABC company issues 100 new shares. The company now has more potential to earn via increased capital meaning a portion of present value is exchanged for potential value.

The disadvantages of stock dilution occur in the short-term when investors perceive an immediate loss. In other words not only is their wealth diluted, but their risk of ownership increases because there is no guarantee the company's new project will lead to an increase in profit margin under the increased ownership. Should the project yield a greater return than the current earnings per share, then the diluted earnings per share would be higher than the earnings per share before dilution and with pre-project profit margins.

Sources:

1. http://bit.ly/adMdy4 (Massachusetts Institute of Technology)
2. http://bit.ly/bva95I  (Investopedia)