Earnings per share and dilution

Earnings per share is net income divided by the number of shares. It exists because profit alone tells a shareholder very little: a company can double its earnings and leave its owners no better off if it also doubled the share count to get there.

Because it is a ratio it moves for two entirely different reasons, either the business earned more or there are fewer shares to divide by. Reading a rising EPS without checking which one happened is the most common mistake made with this number.

Basic EPS divides by the shares actually outstanding. Diluted EPS divides by that plus everything that could become a share: unexercised options, restricted stock, convertible bonds. Diluted is always the lower and the more conservative figure.

The gap between them measures how much of the company existing holders stand to have transferred away. A wide and widening gap is worth understanding, particularly at companies paying a large share of compensation in equity, where it is a real cost that never appears as a cash outflow.

A company buying back its own shares reduces the count, so EPS rises even with profit flat. That is not fake, since the remaining owners really do own a larger fraction, but it is a different achievement from earning more, and calling it EPS growth without qualification obscures which one occurred.

The check is to look at net income and the share count separately over the same years. If profit is flat and the count is falling, the growth is financial engineering; if both are moving the right way, it is not.

For a company with multiple share classes, reported EPS may be expressed per share of a class that is not the one quoted. Berkshire is the standard example: its earnings per share are reported on the Class A basis, and one Class A share is worth fifteen hundred Class B shares. Comparing that EPS against a Class B price produces a price-to-earnings ratio near zero.

The same applies to depositary shares for foreign listings, where reported per-share figures are per ordinary share while the price is per depositary share. Any per-share number is only meaningful beside a price on the same basis, and the two are not always presented that way.