"Diluted" vs. "Basic"

In financial statements, you'll often see references to "diluted" and "basic" earnings per share. What's the difference? Well, it 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. It required companies to report their quarterly earnings per share in two ways: basic and diluted.

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

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 also 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 investors how much of the company's earnings they're 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 (Nasdaq: MSFT  ) . For its fiscal year 2005, ended in June, Microsoft's basic earnings per share were $1.13 and its diluted EPS totaled $1.12. Not such a big difference, right? But let's look at some previous years. In fiscal 2002, the basic EPS came to $0.50 and the diluted EPS totaled $0.48, a 4% difference. Not so earthshaking, I suppose. In 2000, however, Microsoft had a basic EPS of $0.91, vs. $0.85 diluted -- a 7% difference, almost twice as meaningful.

In 2000, more than 600 million additional shares figured in the diluted calculations than in the basic one. In 2002, the difference was about 300 million shares. The effect was smaller in 2002 because the share price fell over the period. When that happens, fewer options are "in the money" -- meaning they'd 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," creating a starker contrast between basic and diluted EPS.

Of course, options are not necessarily all bad. Employee compensation via 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 a company's earnings they're entitled to. They'll also impart a sense of what stock options actually cost a shareholder and will align U.S. accounting standards with international standards currently being developed. That will ultimately help investors compare companies around the globe.

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