What is the difference between EPS? Diluted-EPS? Adjusted EPS?

What is the difference between EPS? Diluted-EPS? Adjusted EPS?

The Company needs to present the Basic and Diluted EPS in its profit and loss statement as per the requirements of the Indian Accounting Standard. EPS also holds importance in the computation of various metrics that the investors generally refer to before investing in any Company

Let us understand what EPS, Diluted EPS, and Adjusted EPS are and what is the difference between the three of them.

What do you mean by EPS?

EPS stands for Earning Per Share. It is the company’s profit allocated to each share issued and subscribed. So, it interprets how much money a company makes for each of its outstanding shares.

Investors widely use it to identify and demonstrate the advantages of investing money into a particular company.

How is EPS calculated?

EPS is calculated by dividing the Company’s net profit by the number of outstanding shares of the Company.

If the company has preference shares issued to its shareholders and declared the dividends, then the same is excluded while computing EPS. This is because the preferred dividends are payable to preference shareholders only so they cannot be included while calculating earnings per share for equity shareholders.

Below is the formula for computing EPS (Also called Basic EPS)

EPS = (Net Income − Preferred Dividends declared*) / Weighted average number of equity shares.

*Dividends paid to preferred shareholders or declared but not paid are subtracted from net income because EPS applies only to equity shareholders so the net income that is attributable to equity shareholders needs to be considered.

Let’s take an example of how to compute the weighted average number of equity shares.

Weighted average number of shares = (2,000 x 12/12) + (800 x 3/12) = 2,200 shares.

Importance of EPS 

• Using EPS one can understand Company’s progress, its financial health, and whether the Company is running in profits or incurring losses.

• Two companies having different capital can have the same EPS, therefore it becomes necessary for the investors to read EPS in conjunction with the P/E ratio, P/E ratio is nothing but Price to Earning ratio which is one of the key metrics that helps an investor understand how the Company’s share price fluctuates relative to its earnings.

Limitations of EPS

• One cannot read EPS in isolation for decision-making. It should be read in conjunction with the P/E ratio or some other relevant ratios..
• EPS calculation doesn’t factor in cash flow, which is a critical aspect of gauging a company’s debt-repaying ability.

What do you mean by Diluted EPS (DEPS)?

1. As the name suggests, diluted EPS is the EPS of a Company after considering the assumption that all the convertible securities of the company will be converted into equity shares.
2. These convertible securities are nothing, but securities issued by the company which has an option for conversion into equity shares after a particular point in time.
3. For Example, the Company issues Preference shares, Debentures, Bonds, stock options, etc. which are convertible. In such case, the investors holding any of these has an option in the future to opt-out from such investment by converting them into equity share investment of the company. If the investor opts for the same, the company is obliged to issue shares to such investors.
4. So, if it is assumed that securities will be converted to equity shares, then the denominator i.e., the number of equity shares will increase, thereby reducing the Basic earnings per share.
5. This assumption doesn’t turn out to be true every time but computing DEPS is like becoming conservative in making decisions based on the worst-case scenario.
6. The Diluted EPS has to be disclosed separately even if it is the same as Basic EPS.

How is DEPS calculated?

Taking Basic EPS as a base, one needs to add the number of dilutive shares to calculate diluted EPS.

It means considering the number of shares that would exist if all a company’s existing potential share obligations were exercised.

Below is the formula for computing DEPS:

Diluted EPS = (Net Income− Preferred Dividends declared + Costs that would have not been incurred if diluted instruments has been exercised**) / (Weighted Average number of equity shares + Exercisable Rights on New Shares)

**Costs that would have not been incurred cover post-tax interest payable on convertible bonds and debentures.

A large difference between a company’s basic EPS and diluted EPS can indicate the potential for dilution of the company’s shares and is a concern for analysts and investors.

Importance of DEPS

• DEPS is a more scientific and stricter approach than Basic EPS as it includes the impact of all potential equity diluters.
• It goes hand in hand with Company’s future expansions if there are significant dilutions in a company in the future.

Limitations of DEPS

• It involves a very complex set of calculations compared to EPS as it includes conversion, tax benefits for bonds, etc.
• One cannot read DEPS in isolation for decision-making. It should be treated as just one component for analyzing Company’s performance.
• DEPS assumes that all its potential debt in terms of bonds, debentures, etc will be converted into equity which may not be the case.
• DEPS calculation also doesn’t factor in cash flow, which is a critical aspect of gauging a company’s debt-repaying ability.

What do you mean by Adjusted EPS?

Adjusted EPS is the earning per share based on net earnings earned by the company after eliminating the impact of non-recurring items forming part of the net earnings.

1. The Basic EPS may get over-reported / under-reported if the Company has some one-time items forming part of its Net income. For example, a one-time sale of Land or Building done by the Company leads to higher Net Income. Here, the focus of adjusted EPS is to look at profits or losses generated from the core operations of the Company on a normalized basis
2. Taking basic EPS as a base, the adjustment is made to the numerator for computing the adjusted EPS thereby eliminating the non-core profits and losses.
3. It gives a far more accurate picture than the Basic and Diluted EPS and one can analyze Company’s future based on returns from core operations.
4. Adjusted EPS is the recommended factor for disclosure in India however a Company doesn’t need to disclose the same.

How to calculate Adjusted EPS

To compute Adjusted EPS, the Adjusted Net Earning is divided by the weighted average shares on a diluted basis.

Below is the formula for computing Adjusted EPS:

Adjusted Net Earnings = Net income of the Company – Preferred Dividends – Non-recurring / Abnormal items.

The net earnings cover all the Revenue and Expense items that form parts of the Company’s profit or loss account. In contrast, adjusted net earnings are after eliminating non-recuring / abnormal/exceptional items like below:

• Profit or loss on sale of an asset, if it has a major contribution to the overall profit/loss of the Company.
• One-time Tax-Payments including payments made against any tax litigations or lawsuits.
• Fines and Penalties.
• Write-offs of the capital assets.

Importance of Adjusted EPS

• It gives a clear picture of income from core operations of the business that is attributable to the equity or potential equity shareholders.
• Adjusted EPS provides a basis for comparison of our business operations between current, past, and future periods by excluding items that we do not believe are indicative of our core operating performance.

Limitations of Adjusted EPS

• It becomes subjective for the company as to which transactions are to be considered Non-recurring and to be eliminated from Net income for calculating the adjusted EPS.
• The Company can manipulate its EPS by choosing which non-recurring transactions to be considered for elimination. 

Let’s take an example of how the EPS, Diluted EPS, and adjusted EPS differ.

Solution:

Amount of Preference dividend:

On convertible shares = 4,000 preference shares x Rs 1 per share = Rs 4,000.

On Non-convertible shares = 1,000 preference shares x Rs 1 per share = Rs 1,000

Diluted shares (with 1:1 ratio) = (4,000 preference shares x 1/1) = 4,000 equity shares 

Total shares after Dilution = 14,000 (10,000 ordinary shares + 4,000 dilutive shares)

Basic EPS = (5,40,000 – 4,000 – 1,000) / 10,000 shares = 53.5 per share

Diluted EPS = (5,40,000 – 1,000) / 14,000 shares =  38.50 per share

Adjusted EPS = (5,00,000 – 4,000 – 1,000) / 14,000 shares = 35.36.

Final word:

Indian Accounting Standard 33 lays down the guidance on the computation of Earning Per Share and its disclosure in the Company’s Financial statement.

EPS, DEPS, and Adjusted EPS play an important role to understand the Company’s ability to generate returns that would be attributable to its equity shareholders.

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