Earnings Dilution 101: Counting Convertability

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We’ve been covering stock market earnings from several vital strategic angles in the past several weeks:

Today, we’re going to dive into an even more fundamental topic: understanding the precise vocabulary used to describe a vital aspect of earnings: dilution.

“Earnings” are the settled financial industry term for, to put it simply, profits. To make the matter a bit confusing, industry professionals use a series of logically interchangeable terms when discussing earnings:

  • Profit
  • Net Income
  • The “Bottom Line”

The point to remember: all of these terms refer to a “net” concept, which includes at least some accounting of both cost and revenue. These terms, however, do not imply that these profits have been adjusted on a per-share basis. Virtually every publically traded stock has a different number of outstanding shares, so this adjustment is essential to making an apples-to-apples comparison between stocks. Earnings per Share (EPS) is, simply, total earnings divided by the total number of shares outstanding. This simple calculation provides a metric that’s almost always more relevant to investors. Financial gains for a stock should, logically, be calculated relative to the cost of acquisition, not some absolute level of profitability.

In contrast to the “basic” EPS metric, you will often see an additional measure called “Diluted Earnings Per Share.” This metric takes into account the fact that outstanding shares are not the only potential legal claims on a firm’s earnings. The Diluted EPS measure includes not only outstanding common stock shares, but other convertible instruments (convertible means the holder can exercise an option to transform the instrument into common stock). Common convertible instruments include:

  • Preferred Stock
  • Stock Options
  • Special Classes of Convertible Bonds

In general, these convertible instruments have greater credit seniority than common shareholders (if the firm defaulted, they would be paid first) but don’t offer the same upside if the firm continues to grow (as convertible securities typically remunerate their holders via a fixed coupon or dividend payment). Thus, we can expect to see most of these convertible securities swapped for common stock if the company in question posts a sustained strong performance. By including convertible securities, we arrive at a more conservative estimate of EPS, which we could describe as a “floor” for current EPS if all possible conversions to common stock were executed.  

As you may have surmised, the gap between Diluted EPS and Basic EPS provides a tool for measuring the overall “dilution” of a given firm: how much potential risk do a firm’s outstanding convertibles pose to common stockholders? Since this information is essential to valuing a stock, the diluted version of EPS is typically more relevant for the majority of investors.

Dilution is not inherently harmful—the funds raised from the issuance of preferred securities may very well be invested in productive assets that will make more money for common stock shareholders in the long run. Like any other financial liability, convertibles shares are simply another factor the savvy investor must consider when evaluating the risks and potential rewards of owning a security.

Understanding the mechanics of stock trading is a powerful first step. In today’s market, good data is the key to translating this information into market-beating profits. If you’d like to dive deeper into how our platform is using data to help smaller investors get in on the news-based profits hedge funds have been milking for years, we recommend one of our totally free virtual training sessions. You can claim a spot in our next session using the button below:

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