Introduction
In this practice question from Appendix C, we’ll explore how to calculate the fully diluted earnings per share (EPS) for a company. Calculating EPS is a critical skill for a general securities representative, as it helps determine the value of an investment. This particular practice question will reinforce your understanding of which financial instruments affect the EPS calculation.
Understanding Fully Diluted Earnings Per Share
Fully diluted earnings per share is a metric used to show the quality of a company’s earnings per share if all convertible securities were exercised. It reflects the lowest possible EPS a company could have if all securities that could be converted into shares are indeed converted. This is a more conservative measure as it provides an insight into the worst-case dilution scenario of EPS.
Instruments Affecting Fully Diluted EPS
Various financial instruments could potentially convert into equity, affecting the diluted EPS calculation. These include:
- Options: Rights given to employees, which allow them to purchase stock at a certain price within a specific time frame.
- Warrants: Similar to options, warrants are issued by the company allowing the holder to purchase shares at a specific price before expiration.
- Convertible Securities: Bonds or preferred stock that can be converted into a certain number of common shares at the holder’s option.
None of these are included when calculating basic EPS, but they are essential when calculating fully diluted EPS.
Conclusion
Understanding and calculating fully diluted EPS is crucial for anticipating the implications of convertible securities on a company’s earnings per share. Mastery of this concept is invaluable when working as a general securities representative and will help you in your Series 7 exam preparation.
For continued learning, make use of the quizzes provided below, and refer to the glossary and additional resources for comprehensive understanding.
Glossary
- Earnings Per Share (EPS): The portion of a company’s profit allocated to each outstanding share of common stock.
- Diluted EPS: The EPS figure that accounts for all possible conversions of convertible securities.
- Convertible Securities: Financial instruments like bonds or preferred stock that can be converted into common shares.
Additional Resources
Quizzes
Enhance your understanding of fully diluted EPS through the following sample exam questions. Complete the quiz below and check your answers and explanations for immediate feedback.
### Which financial instrument affects fully diluted EPS?
- [ ] Preferred stock only
- [x] Options, warrants, and convertible securities
- [ ] Long-term debt obligations
- [ ] Treasury stock
> **Explanation:** Fully diluted EPS accounts for all potential shares that could be created from instruments like options, warrants, convertible bonds, and convertible preferred stock. It reflects the lowest possible EPS if all dilutive securities are exercised.
### What is a characteristic of diluted EPS?
- [x] Reflects the lowest possible EPS
- [ ] Always higher than basic EPS
- [x] Includes all convertible securities
- [ ] Excludes warrants
> **Explanation:** Diluted EPS reflects the lowest possible EPS because it accounts for all convertible securities as if they have been converted, leading to more shares outstanding.
### EPS without conversion of convertible securities is called:
- [x] Basic EPS
- [ ] Diluted EPS
- [ ] Net EPS
- [ ] Pro forma EPS
> **Explanation:** Basic EPS does not include potential dilution from options, warrants, or convertible securities. It reflects earnings only on the currently outstanding shares.
### If all options are exercised, the impact on EPS is:
- [x] Decreasing EPS
- [ ] No impact on EPS
- [ ] Increasing EPS
- [ ] Negligible impact on EPS
> **Explanation:** Exercising options increases the number of outstanding shares, which will decrease EPS unless net income grows proportionately.
### Options affect which EPS calculation?
- [x] Diluted EPS
- [ ] Basic EPS
- [x] Adjusted EPS
- [ ] Non-GAAP EPS
> **Explanation:** Options affect the diluted EPS calculation, as they represent potential shares that could be added to the outstanding count.
### Which securities are not included in basic EPS?
- [x] Convertible bonds
- [ ] Common stock
- [ ] Preferred dividends
- [ ] Earnings retained
> **Explanation:** Basic EPS does not include potential dilution from convertible bonds or other convertible securities. It only considers shares currently outstanding.
### The issuance of which increases fully diluted shares?
- [x] Warrants
- [ ] Bonds
- [x] Convertible preferred stock
- [ ] Debt securities
> **Explanation:** Warrants and convertible preferred stock can be converted into common stock, increasing the number of shares used in the diluted EPS calculation.
### Treasury stock affects which EPS?
- [ ] Diluted EPS only
- [ ] Basic EPS only
- [x] Neither
- [ ] Both
> **Explanation:** Treasury stock is not included in the EPS calculations because these shares are held by the company and are not considered outstanding.
### Why calculate diluted EPS?
- [x] Assess worst-case EPS scenario
- [ ] Replace basic EPS
- [ ] Only for accounting purposes
- [ ] Consider dividends only
> **Explanation:** Calculating diluted EPS is important for assessing the worst-case scenario of EPS if all convertible securities are exercised.
### Does diluted EPS assume full conversion?
- [x] True
- [ ] False
> **Explanation:** Diluted EPS assumes that all dilutive securities are converted into common shares, which gives a more conservative perspective of a company's earnings per share.
Using these quizzes and resources, continue to build your understanding and proficiency in calculating fully diluted earnings per share, which is an essential topic for the FINRA Series 7 exam.