Basic vs Diluted EPS: Treasury Stock and If-Converted Methods
By SimplyCPA · 24 October 2026
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- Basic EPS: (Net income − preferred dividends) ÷ weighted-average common shares outstanding.
- Preferred dividends: Deduct cumulative preferred dividends for the year whether declared or not; non-cumulative only if declared.
- Options and warrants: Treasury stock method — assume exercise, and that the proceeds buy back shares at the average market price.
- Convertibles: If-converted method — add back after-tax interest (or preferred dividends) and add the conversion shares.
- Antidilution: Ignore any security that would increase EPS.
What EPS measures
Earnings per share tells a common shareholder how much of the period's profit belongs to each share. Public companies present basic EPS and, when they have securities that could become shares, diluted EPS.
Basic EPS
Basic EPS = (net income − preferred dividends) ÷ weighted-average common shares outstanding.
- Shares are weighted by the fraction of the year they were outstanding.
- Stock dividends and stock splits are applied retroactively — treated as if they happened at the start of the earliest period shown.
Net income $500,000. Cumulative preferred dividends for the year $50,000. 100,000 common shares outstanding on 1 January; 20,000 more issued on 1 July.
Weighted-average shares = 100,000 + 20,000 × 6/12 = 110,000.
Basic EPS = ($500,000 − $50,000) ÷ 110,000 = $4.09.
Diluted EPS
Diluted EPS asks: what if every security that could turn into common shares had done so? Two methods do the work:
- Treasury stock method (options and warrants) — assume exercise, and assume the cash received buys back shares at the average market price. Only the net new shares are added.
- If-converted method (convertible bonds and convertible preferred) — assume conversion at the start of the year (or at issue, if later). Add back the after-tax interest saved (bonds) or the preferred dividends no longer paid, and add the conversion shares.
Continuing the example:
Options: 10,000 options with an exercise price of $20; average market price $25. Proceeds $200,000 buy back 8,000 shares, so 2,000 net new shares.
Convertible bonds: $200,000 of 6% bonds, convertible into 10,000 shares, outstanding all year; tax rate 21%. After-tax interest = $12,000 × (1 − 0.21) = $9,480. Their incremental EPS is $9,480 ÷ 10,000 = $0.95, below basic EPS, so they're dilutive.
Diluted EPS = ($450,000 + $9,480) ÷ (110,000 + 2,000 + 10,000) = $459,480 ÷ 122,000 = $3.77.
Antidilution
A security is left out of diluted EPS if including it would raise EPS (or reduce a loss per share). Options are antidilutive when the exercise price is above the average market price; convertibles are antidilutive when their incremental EPS is above basic EPS. When a company reports a loss from continuing operations, potential shares are generally antidilutive.
Practice MCQs
1. A company has non-cumulative preferred stock. No preferred dividends were declared this year. What is deducted from net income for basic EPS?
(A) The full annual preferred dividend (B) Nothing (C) Half the dividend (D) The dividend in arrears
Answer: B. Non-cumulative dividends are deducted only if declared.
2. 5,000 options have an exercise price of $30; the average market price is $40. How many incremental shares does the treasury stock method add?
(A) 5,000 (B) 3,750 (C) 1,250 (D) 0
Answer: C. Proceeds $150,000 ÷ $40 = 3,750 shares bought back; 5,000 − 3,750 = 1,250.
Full coverage is in our FAR equity and EPS notes.