Question

The SEC requires that firms report both basic and diluted earnings per share in their 10-K reports. Why do firms’ basic EPS and diluted EPS differ? Which EPS number is more informative to you as an investor?

Answer 1

Earnings Per share depicts a company's earnings on a per share basis.EPS is obtained by deducting the preferred dividend if any from the Net Income and then dividing it with number of shares outstanding.EPS.Both EPS and Diluted EPS serve the purpose of indicating the firm's profitability.Basic EPS only takes into account the common stock,diluted EPS on the other hand takes into consideration convertible securities like convertible preferred stock or convertible bonds that can be converted into stock in the future..The diluted EPS takes into consideration the effect an increase in the number of shares outstanding of a company can have on the EPS.This increase in the number of shares might arise due to convertible bonds or preferred stock being converted to common stock and this might lead to lowering of the EPS of the firm.Hence a company with convertible securities like convertible preferred stock will have a diluted EPS lower than basic EPS.

From an investors perspective the diluted EPS is more informative than a basic EPS.This is because of the fact that it will provide an investor with an estimate of how conversion of securities and the dilution that occur as a result of it will have on their profitability per share.A basic EPS is a simpler measure in comparison to diluted EPS and as a result is not as informative to the investor as a diluted EPS.