"Diluted" vs. "Basic" Earnings

In financial statements, you'll see references to "diluted" and "basic" earnings per share. What's the difference? The terms reflect some interesting changes in how companies report their earnings.

At the end of 1997, the Financial Accounting Standards Board (FASB) instituted a new ruling, requiring companies to report their quarterly earnings per share (EPS) 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, 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 other owners' potential claims 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. Consider Microsoft's (Nasdaq: MSFT  ) earnings per share (EPS) for fiscal 2006. The basic EPS was $1.21 and the diluted EPS was $1.20, a difference of just a penny. Not so earthshaking, I suppose. But in 2000, basic EPS was $1.81, vs. $1.70 diluted -- a 6% difference, and quite a bit more meaningful.

In 2000, Microsoft's diluted calculations factored in 347 million more shares than its basic calculations. In 2006, the difference was just 93 million shares. The effect was smaller in 2006 because the share price has fallen over the past several years. 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" lags 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," establishing a starker contrast between basic and diluted EPS.

Of course, options aren't necessarily all bad. Using options as employee compensation lets some companies attract and keep talented employees. It can also reduce current salary expenses, leaving more money to help the firm grow.

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

Learn more about how to interpret financial statements in our "Crack the Code: Read Financial Statements Like a Pro" How-to Guide, or give any of our online how-to guides a whirl. More than 90% of Fools who've taken them consistently give them high marks. Besides, we offer a satisfaction guarantee, or your money back. (Some of them are even free!)

Longtime Fool contributor Selena Maranjian owns shares of Microsoft, a Motley Fool Inside Value pick. The Fool has a disclosure policy.

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