Basic and Diluted Earnings per Share

Updated for the 2026-2027 CFA® Level I curriculum.

Earnings per share tells you how much net income a company earned for each share of common stock. CFA Level I tests two versions of this number: basic EPS and diluted EPS. The difference matters because diluted EPS shows what happens to earnings per share after including the assumed effects of instruments that dilute earnings per common share.

Quick Answer

Basic EPS divides income available to common shareholders by the weighted average number of common shares outstanding. Diluted EPS adds the effect of all dilutive securities, using the if-converted method for convertible bonds and preferred stock, and the treasury stock method for options and warrants. A company with only common stock outstanding reports basic EPS only. A company with convertible securities or options reports both.

Key Takeaways

• Basic EPS equals (net income minus preferred dividends) divided by weighted average common shares outstanding.

• Diluted EPS applies the if-converted method to convertible bonds and convertible preferred stock.

• Diluted EPS applies the treasury stock method to stock options and warrants.

• A security is dilutive only if including it lowers EPS. If it raises EPS, it is antidilutive and gets excluded.

• Companies with a simple capital structure report basic EPS only. Companies with a complex capital structure report both basic and diluted EPS.

• Weighted average shares outstanding reflect the time shares were actually outstanding during the period, including retroactive adjustment for stock splits and stock dividends.

What You Need to Know for CFA Level I

• The LOS asks you to describe, calculate, and interpret EPS for both simple and complex capital structures, including handling antidilutive securities.

• You must know both formulas cold: basic EPS and diluted EPS.

• You must be able to apply the if-converted method and the treasury stock method without hesitation.

• Test each potentially dilutive security separately. The exam often includes one dilutive and one antidilutive security in the same problem.

• This note covers only the EPS calculation. It does not cover common-size income statement ratios or non-recurring item adjustments, which are tested in separate notes.

• The most common trap is including an antidilutive security in the diluted EPS calculation. Always check the direction of the EPS effect before adding anything to the formula.

Simple vs. Complex Capital Structures

A company has a simple capital structure if it has no potentially dilutive instruments. It may also have non-convertible debt or non-convertible preferred shares. These companies report basic EPS only.

A company has a complex capital structure if it has convertible bonds, convertible preferred stock, stock options, warrants, or any other instrument that could increase the share count. These companies must report both basic EPS and diluted EPS.

The exam signals a complex capital structure by mentioning any of these instruments in the problem. If you see convertible debt, options, or warrants, expect a diluted EPS calculation.

Calculating Basic EPS

where:

• Net Income is total income for the period, taken from the income statement,

• Preferred Dividends include current-period cumulative preferred dividends whether declared or not, and dividends declared on non-cumulative preferred shares. Subtract these because preferred shareholders have a prior claim on earnings, and

• Weighted Average Common Shares Outstanding is the number of common shares outstanding, weighted by the portion of the year each share was outstanding.

Weighted Average Shares: Why Timing Matters

If a company issues new shares partway through the year, those shares count only for the portion of the year they were outstanding. If a company repurchases shares, the same logic applies in reverse.

Stock splits and stock dividends are different. These are applied retroactively to all shares outstanding before the split or dividend, as if the split had occurred at the start of the earliest period presented. This keeps EPS comparable across periods.

Calculating Diluted EPS

Diluted EPS answers a different question: what would EPS look like if every dilutive security converted into common stock? The formula builds on basic EPS by adjusting both the numerator and the denominator.

where:

• Convertible debt interest (1 - t) adds back the after-tax interest expense the company would no longer pay if bondholders converted to equity. The tax rate is t,

• Convertible Preferred Dividends are added back because those dividends would no longer be paid if preferred shares converted to common,

• Shares from Conversion are the new common shares issued if convertible securities converted, and

• Shares from Options/Warrants come from the treasury stock method, explained below.

If-Converted Method

Use this method for convertible bonds and convertible preferred stock. Assume conversion at the start of the period, or the issue date if the instrument was issued later. Weight the additional shares and related earnings adjustment consistently:

1. Add back after-tax interest expense (for convertible bonds) or preferred dividends (for convertible preferred) to the numerator.

2. Add the number of common shares the conversion would create to the denominator.

Treasury Stock Method

Use this method for stock options and warrants. The logic: assume option holders exercise, the company collects the exercise proceeds, and uses those proceeds to buy back shares at the average market price.

1. Calculate proceeds: Exercise price × Number of options.

2. Calculate shares repurchased:.

3. Net new shares added to the denominator equal options issued minus shares repurchased.

No adjustment is made to the numerator under this method. Only the denominator changes.

Identifying Dilutive vs. Antidilutive Securities

A security is dilutive if including it in the diluted EPS calculation lowers EPS compared to basic EPS. A security is antidilutive if including it would raise EPS (or shrink a loss per share). Antidilutive securities get excluded from the diluted EPS calculation entirely.

Assess each issue or series separately, then include instruments in sequence from most dilutive to least dilutive. Retest each addition against the EPS reached after the earlier additions. A convertible bond might be dilutive while a convertible preferred share in the same company is antidilutive. Include only the securities that pass the dilutive test.

Working Through the Share Denominator

A company begins the year with 1,000,000 common shares, issues 200,000 shares for cash on April 1, and repurchases 120,000 shares on October 1. Assume no other share changes.

The ending balance is 1,080,000 shares. Using that balance for the whole year would understate the denominator because more shares were outstanding during the middle six months.

If income available to common shareholders is $2,240,000:

Now assume a two-for-one split occurs on December 1. The split does not bring new resources into the company, so restate the earlier share amounts for the split rather than weighting the extra split shares for only December.

The lower EPS reflects twice as many shares representing the same earnings. It does not indicate a deterioration in the business. By contrast, a cash share issue enters the denominator only from its issue date.

Working Example

Setup

Hartwell Logistics reports the following for the year:

• Net income: $10,000,000

• Preferred dividends (non-convertible): $1,000,000

• Weighted average common shares outstanding: 4,000,000

• Convertible bonds outstanding: $5,000,000 face value, 6% coupon, convertible into 250,000 common shares. Tax rate: 25%.

• Stock options outstanding: 100,000 options, exercise price $20. Average market price during the year: $25.

Step 1: Calculate Basic EPS

Step 2: Apply the If-Converted Method to the Convertible Bonds

New shares from conversion: 250,000

Step 3: Apply the Treasury Stock Method to the Options

Step 4: Calculate Diluted EPS

The options first reduce EPS to about $2.2388. The bonds add $0.90 of earnings per new share, below that adjusted EPS, so adding them also dilutes EPS. The final diluted EPS is about $2.16. An analyst comparing Hartwell to a peer should use diluted EPS, since it reflects the lower earnings per share investors would see if all conversion rights were exercised.

Common Exam Traps

Including an antidilutive security

If adding a security to the diluted EPS calculation would raise EPS instead of lowering it, leave it out. Candidates often add every convertible instrument automatically without testing the direction of the effect.

Forgetting the tax adjustment on convertible debt

The interest add-back for convertible bonds must be after-tax. Adding back pre-tax interest overstates the numerator and overstates diluted EPS.

Confusing basic EPS weighting with diluted EPS share counts

Weighted average shares outstanding in the basic EPS denominator reflect actual time outstanding. Shares added for diluted EPS assume conversion or exercise occurred at the start of the period, or the date of issue if later, with appropriate time weighting.

Mixing up EPS with common-size ratios

EPS is a per-share dollar figure, not a ratio of income statement line items to revenue. Common-size analysis is covered in a separate note and uses a different framework entirely.

Skipping the treasury stock method's proceeds step

Some candidates jump straight to subtracting options from shares outstanding. The method requires calculating repurchased shares first, using the average market price, before finding the net share addition.

Practice Question

Bellroy Manufacturing reports net income of $6,000,000, non-convertible preferred dividends of $500,000, and $2,000,000 weighted average common shares. It has 50,000 options outstanding throughout the year with a $15 exercise price. The average market price is $10. Which answer correctly states diluted EPS and explains the option treatment?

1. $2.75; exclude the options because they are antidilutive.

2. $2.68; include all 50,000 options as additional shares.

3. $3.00; omit preferred dividends from income available to common shareholders.

FAQs About Basic and Diluted Earnings per Share