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Diluted earnings per share is a measure of earnings based on the, usually hypothetical, situation of every possible share being taken up. This takes account of situations such as stock options and convertible bonds that could mean the total number of shares increases. While diluted earnings per share is something of a worst case scenario and not very relevant to the real world, it can be used to compare different companies on an equal basis.
Earnings per share is designed as a measure of how well a company is using the money invested into it when it went public. The precise method of calculating the figure varies, depending on accounting practices, but the general principle is that it is the total profits divided by the number of shares in the company. This makes it easier to assess a company's performance in situations such as when one company has a higher profit than a rival, but also has many more shares, meaning that profit is less valuable in terms of individual shares. In principle, the earnings per share represents the dividend the company would pay if it decided to distribute all its profits to shareholders, rather than retain any of it for future spending.
This basic figure doesn't take into account that the total number of shares may change. This is because of various financial set-ups that may give people the right to take new shares in the future. This would increase the number of shares and thus dilute their individual value. These are taken into account when calculating diluted earnings per share.
There are several situations that could lead to stock dilution. One is the simple stock option where, most commonly, an employee is allowed to buy newly created shares at a fixed price if they chose to do so. Another is preferred stock, a hybrid between a standard stock investment and a debt security, such as a bond. Usually a holder of preferred stock has the right to convert it into standard, or common, stock. There is a similar product known as a convertible bond, which the holder can exchange for stock if he chooses to do so.
To take account of these, two adjustments are usually made to the basic calculation of earnings per share when calculating diluted earnings per share. The first is to remove the dividends paid out to holders of preferred stock from the income figure; this is needed to make sure the figures balance. The second is to increase the figure for the number of shares in the company to take account of all the options that could lead to additional stock being created.
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