FOOL'S SCHOOL DAILY Q&A

Diluted vs. Basic Earnings

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By Selena Maranjian (TMF Selena)
November 13, 2002

Q. In financial statements, I see references to "diluted" and "basic" earnings per share. What's the difference?

A. This reflects some interesting changes in how companies report their earnings. At the end of 1997, a new rule went into effect, instituted by the Financial Accounting Standards Board (FASB). It required companies to report their quarterly earnings per share (EPS) in two ways: basic and diluted.

This is important stuff for investors to understand, as corporate per-share profits are, in many ways, at the core of all things financial. Per-share profits show an investor her share of a company's total profits. Fools should pay attention to the diluted, not basic, numbers.

Basic EPS is net income, less any preferred stock dividends, divided by the weighted average number of common stock shares outstanding during the reporting period. Diluted EPS takes into account stock options, warrants, preferred stock, and convertible debt securities, all of which can be converted into common stock. These common-stock equivalents represent the potential claims of other owners on earnings, and show the investor how much of the company's earnings she's entitled to, at a minimum.

Any increase in the number of shares of stock dilutes the earnings attributed to each share. The difference can sometimes be dramatic. As an example, consider Microsoft's (Nasdaq: MSFT) earnings per share (EPS) for fiscal year 2002. The basic EPS was $1.45 and the diluted EPS was $1.41, a 3% difference. In 2000, basic EPS was $1.81 vs. $1.70 diluted -- a 6% difference, twice as meaningful. In 2000, there were 347 million more shares that figured into the diluted calculations than in the basic numbers. In 2002, the difference was 147 million shares.

The reason why the effect is smaller in 2002 is that the share price has fallen over the last year or two. When the share price drops, fewer options are "in the money" (meaning they would have value if exercised, since their "strike price" or "exercise price" is below the current stock price). Out-of-the-money options don't count as shares for diluted EPS. In the rosy bubble days of yore, most issued options were "in the money," so there was a starker contrast between basic and diluted EPS.

Options are not necessarily all bad. Employee compensation in the form of options does permit some companies to attract and keep talented employees and also to reduce current salary expenses, leaving more money to help the firm grow.

Since many firms issue gobs of stock options, the new rules will help investors more accurately determine how much of company earnings they're entitled to, and will impart a sense of what stock options actually cost a shareholder. The change will also align U.S. accounting standards with international standards being developed, ultimately helping investors compare companies around the globe.

Learn more on our Reading Financial Statements discussion board (free trial available).

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This question and answer is adapted from The Motley Fool Money Guide: Answers to Your Questions About Saving, Spending and Investing. For answers to this and 499 other common money questions, check it out -- it's a handy resource.