Diluting shares is like cutting a pizza into smaller pieces.

In financial statements, you'll often see references to "diluted" and "basic" earnings per share. Understanding the difference between the two numbers can help you make smarter investment decisions.

Let's start with earnings per share itself. It simply reflects a company's net income -- its bottom line of profit -- divided by its number of shares. So \$150 million in net income and 100 million shares gives you earnings per share, or EPS, of \$1.50. There's a problem, though, because you can count a company's number of shares in several ways. That's where "basic" and "diluted" EPS numbers come in.

In 1997, a new rule went into effect, instituted by the Financial Accounting Standards Board. It changed how companies report their earnings, requiring those with complex capital structures (which include most public companies that you've heard of) to report their quarterly earnings per share in two ways: basic and diluted.

## Math matters

Basic EPS takes net income, subtracts preferred dividends, and then divides by the weighted average number of shares of common stock outstanding during the period in question. Diluted EPS doesn't use the number of shares outstanding, instead using the number of possible shares outstanding. That's because often, companies have issued convertible securities such as stock options (for employees), warrants, convertible preferred shares, and so on. Because those could turn into shares of stock at some point, the diluted EPS figure is a more conservative one, reflecting what EPS would look like if all convertible securities had been converted into stock and thus there were more shares. Diluted EPS is almost always equal to or lower than the basic EPS figure.

Why does the number of shares matter so much? Well, if you're a shareholder of stock in a company and it suddenly has more shares, then your proportional claim on the company's earnings shrinks. Imagine, for example, cutting a pizza into 10 pieces instead of eight; each will be smaller.

## What to do

Here are a few examples of some familiar companies, with notable differences in their numbers:

Company

Trailing 12-Month EPS, Basic

Trailing 12-Month EPS, Diluted

Priceline Group

\$45.03

\$44.28

Walt Disney

\$4.31

\$4.26

Wells Fargo

\$4.15

\$4.08

FedEx

\$8.01

\$7.91

Intuitive Surgical

\$11.74

\$11.49

It's interesting to note these differences, because they can reveal when a company is issuing a lot of stock options to employees. That can have a dilutive effect on shares when the options are exercised, but it's not all bad if the company is effectively using those options to attract and retain skilled employees. Options can also be used to reduce current salary expenses, leaving more money to help the company grow.

Note, too, that you'll more often see small differences or no difference in the numbers with large, established companies. Smaller companies will sometimes see bigger differences if, for example, they're issuing a lot of stock options.

The bottom line: Investors should focus primarily on the diluted EPS, rather than the basic EPS.