An increase in the number of common shares outstanding dilutes (reduces) earnings per share.
For instance, if company ABC has an outstanding issue of preferred stock that is convertible into shares of common stock at a rate of three shares of common stock for two shares of preferred stock. The conversion would increase the number of common shares outstanding and possibly dilute earnings per share.
Why would the conversion affect earnings per share (EPS)?
To calculate earnings per share, only the common stock are considered. EPS is computed by dividing the common shareholders’ share of the company’s net income by the average number of common shares outstanding.
A common stockholder keeping an eye on the EPS of a company, would want to know what effect the conversion of preferred stock would have on EPS of common stock. A concerned stockholder would look at two figures to assess the potential dilution that may occur.
These figures are:
- Basic earnings per share
2. Diluted earnings per share.
Basic earnings per share is computed on the basis of the weighted average number of common stock actually outstanding during the financial year. The potential dilution represented by the convertible preferred stock is not included in this figure.
Diluted earnings per share includes the effect that conversion of the preferred stock would have on the basic earnings per share.
A significant difference between basic and diluted earnings per share indicates the risk that future earnings per share may be reduced by conversions of other securities into additional shares of common stock.