Earnings per share (EPS) is a common financial metric used to express the profitability of a company. However, in order to account for all of a company's obligations that could result in additional shares being issued, diluted earnings per share can be a much better metric to use.

Here's what diluted EPS is and how to calculate it.

What is Diluted EPS?
A company's earnings per share, or EPS, is simply the company's total income minus any preferred dividends, divided by the number of outstanding shares.

Note: For accuracy, it is best to use a weighted average of the company's outstanding shares for the period.

However, this doesn't paint a completely accurate picture of the company's financial condition. Many companies have other existing obligations that could result in additional shares being issued. For example, if a company issues stock options to its employees or has any outstanding bonds that could be converted into common stock, then it could result in the issuance of more shares -- and the dilution of existing shareholders.

For this reason, it can be more useful to express financial metrics such as EPS using the "fully diluted" share count -- that is, the number of shares that would exist if all of these obligations were met. To calculate diluted EPS, we modify the share count in the EPS formula to account for the extra shares.

How to determine the effect of options
Diluted shares can be tricky to calculate, especially when it comes to stock options, which are the most common obligation to issue shares that companies face. Basically, when a company issues stock options at a certain exercise (strike) price, you only need to account for the intrinsic value of the options and how much stock could be purchased with that amount of money.

First, multiply the number of issued stock options by the exercise price. This tells you how much would be paid in order to exercise the options.

Next, divide that result by the current market price of the stock to determine how many shares could be purchased for the exercise price of the options.

Finally, subtract this figure from the number of options outstanding to determine the excess shares that would need to be issued to meet these obligations.

This is the number you add to the outstanding share count to determine the number of shares that could exist if the options were exercised.

An example
Let's say that a company earns \$1 million and has 10 million outstanding shares and no preferred dividends to pay. A basic calculation shows an EPS of \$0.10. We'll also assume that shares trade for \$20 and the company has issued 1 million stock options to buy shares for \$15. Using the method discussed above, we can calculate the number of diluted shares like this:

And then diluted EPS can be calculated using this result:

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