Diluted Earnings Per Share

The Diluted Earnings Per Share or diluted EPS is used to help determine if a company’s stock is overvalued or undervalued. This is different than the basic EPS in one major way.

Unlike the basic EPS which only compares the stocks earnings to the current shares outstanding. The Diluted EPS takes into consideration the number of shares that can theoretically exist.

It assumes a worst case scenario where everyone who holds stock options, grants, and convertible bonds exercises their rights to receive the stock without actually purchasing it. This could make more shares and make a stock that looks cheap become expensive.

Using The Ratio

The most effective way of using this ratio is to compare it to the price of the stock. Let us look at two different companies. Company A and Company B both have a stock that is trading at $40. They both also have an EPS of $4 per share.

If we looked at how each company measures up we would find that they both have p/e ratio of $10, and therefore are both priced at around the same when compared to how much money the company earns.

P/E ratio = Stock’s value/EPS

Company A = $40/$4 or $10

Company B = $40/$4 0r $10

However Company A has a lot of shares that can potentially be created in the short term. This drives their DEPS down to $3. Company B does not have this problem and so their DEPS is still $4. If we plugged DEPS into the equation instead of EPS it would tell a different story.

Company A = $40/$3 or $13.33

Company B = $40/$4 or $10

Taking the new factors into consideration we find that Company B makes a better investment because they have a lower P/E ratio when factoring in shares that can be created.

Because the Diluted Earnings Per Share takes the worst case scenario under consideration it is considered to be the most accurate EPS by most fundamental traders.