A financial ratio that relates net income to the maximum number of common shares if all possibly dilutive stock options or embedded conversion rights were exercised (to the effect of converting bonds and preferred convertible stock to common stock, employee stock options). The formula of calculating diluted earnings per share (diluted EPS) for a company that has preferred stock in addition to common shares:
In this formula, the new shares refer to any additional shares issued or would have been issued at conversion. For a company that issued convertible debt, diluted EPS is given by:
This formula takes into account after-tax interest on convertible debt and the additional common shares that would have been issued at conversion.
The dilutive financial contracts, if converted or assumed to be converted, will reduce earnings per share, as the number of shares outstanding will be assumed to be increased. A company that has a simple capital structure (no dilutive financial instruments) will have its basic EPS equal to its diluted EPS.
