Chapter19: Share-Based Compensation and Earnings Per Share
At times, the effect of the conversion or exercise of potential common shares would be to increase, rather than decrease, EPS. These we refer to as antidilutive securities the effect of the conversion or exercise of potential common shares would be to increase rather than decrease, EPS.. Such securities are ignored when calculating both basic and diluted EPS.
To assume 4 million shares were sold at the $32.50 exercise price and repurchased at the lower market price ($25) would mean reacquiring 5.2 million shares. That's more shares than were assumed sold. Because the effect would be antidilutive, we would simply ignore the warrants in the calculations.p. 1093
In our continuing illustration, only the stock warrants were antidilutive. The other potential common shares caused EPS to decline when we considered them exercised or converted. In the case of the executive stock options, it was readily apparent that their effect would be dilutive because the exercise price was less than the market price, indicating that fewer shares could be repurchased (at the average market price) than were assumed issued (at the exercise price). As a result, the denominator increased. When only the denominator of a fraction increases, the fraction itself decreases. On the other hand, in the case of the warrants, it was apparent that their effect would be antidilutive because the exercise price was higher than the market price, which would have decreased the denominator and therefore increased the fraction.
When a company has a net loss, rather than net income, it reports a loss per share. In that situation, stock options that otherwise are dilutive will be antidilutive. Here's why. Suppose we have a loss per share of $2.00 calculated as ($150 million) ÷ 75 million shares = ($2.00). Now suppose stock options are outstanding that, if exercised, will increase the number of shares by 5 million. If that increase is included in the calculation, the loss per share will be $1.88 calculated as ($150 million) ÷ 80 million shares = ($1.88). The loss per share declines. This represents an increase in performance—not a dilution of performance. The options would be considered antidilutive, then, and not included in the calculation of the net loss per share. Any potential common shares not included in dilutive EPS because they are antidilutive should be revealed in the disclosure notes.
For convertible securities, though, it's not immediately obvious whether the effect of their conversion would be dilutive or antidilutive because the assumed conversion would affect both the numerator and the denominator of the EPS fraction. We discovered each was dilutive only after including the effect in the calculation and observing the result—a decline in EPS. But there's an easier way.
To determine whether convertible securities are dilutive and should be included in a diluted EPS calculation, we can compare the “incremental effect” of the conversion (expressed as a fraction) with the EPS fraction before the effect of any convertible security is considered. This, of course is our basic EPS. Recall from Illustration 19-11 that basic EPS is $2.00.
For comparison, we determine the “earnings per incremental share” of the two convertible securities:
Conversion of bonds.
Conversion of preferred stock.
Order of Entry for Multiple Convertible Securities
A convertible security might seem to be dilutive when looked at individually but, in fact, may be antidilutive when included in combination with other convertible securities. This is because the order of entry for including their effects in the EPS calculation determines by how much, or even whether, EPS decreases as a result of their assumed conversion. Because our goal is to reveal the maximum potential dilution that might result, theoretically we should calculate diluted EPS using every possible combination of potential common shares to find the combination that yields the lowest EPS. But that's not necessary.p. 1094
We can use the earnings per incremental share we calculated to determine the sequence of including securities' effects in the calculation. We include the securities in reverse order, beginning with the lowest incremental effect (that is, most dilutive), followed by the next lowest, and so on. This is, in fact, the order in which we included the securities in our continuing illustration.
a10% × $70 million = $7 million
b8% × $100 million = $8 million
cExercise of warrants:
d 12.5% × $200 million = $25 million
*Because the incremental effect of conversion of the preferred stock ($2) is higher than EPS without the conversion of the preferred stock, the conversion would be antidilutive and is not considered in the calculation of diluted EPS.