How do you identify anti-dilutive securities and exclude them from diluted EPS?
My CFA Level I textbook says that anti-dilutive securities must be excluded from diluted EPS, but I'm not always sure how to tell if a security is anti-dilutive. Is it just about whether EPS goes up? And do you test each security individually or together? The ordering seems to matter.
Anti-dilutive securities are those that, if included in the diluted EPS calculation, would increase EPS (or decrease a loss per share). They must be excluded because the purpose of diluted EPS is to show the worst-case scenario.
Rule 1 — Options and Warrants:
An option or warrant is anti-dilutive when the exercise price exceeds the average market price. Under the treasury stock method, you would repurchase more shares than you issue, which would reduce the denominator — this cannot happen, so the options are excluded.
Example: Elmsford Tech has options for 50,000 shares with an exercise price of $60. Average market price = $45.
- Since $60 > $45, these options are anti-dilutive and excluded entirely.
Rule 2 — Convertible Securities (Per-Share Impact Test):
For convertible bonds or convertible preferred, calculate:
Per-Share Impact = Income Effect / Share Effect
If this value exceeds basic EPS, the security is anti-dilutive.
Example: Lakewood Industries has basic EPS of $3.20. It has two convertible securities:
| Security | Income Effect | Share Effect | Per-Share Impact |
|---|---|---|---|
| Conv. Bond A | $180,000 (after-tax interest) | 80,000 shares | $2.25 |
| Conv. Preferred B | $240,000 (preferred dividend) | 60,000 shares | $4.00 |
- Bond A: $2.25 < $3.20 basic EPS → Dilutive (include)
- Preferred B: $4.00 > $3.20 basic EPS → Anti-dilutive (exclude)
Rule 3 — The Ordering (Ranking) Matters:
When multiple potentially dilutive securities exist, you must include them in order from most dilutive to least dilutive and recheck dilutiveness at each step.
| Step | Include | Numerator | Denominator | Diluted EPS | Dilutive? |
|---|---|---|---|---|---|
| Basic | — | $3,200,000 | 1,000,000 | $3.20 | — |
| +Options (40K net shares) | Options | $3,200,000 | 1,040,000 | $3.08 | Yes |
| +Bond A ($2.25/share) | Bond A | $3,380,000 | 1,120,000 | $3.02 | Yes |
| +Preferred B ($4.00/share) | Preferred B | $3,620,000 | 1,180,000 | $3.07 | No — STOP |
Preferred B is excluded because adding it increases diluted EPS from $3.02 to $3.07. Even though it passed the initial screen against basic EPS in some scenarios, the sequential test reveals it is anti-dilutive in context.
Special case — Net loss:
When a company reports a net loss, all potentially dilutive securities are anti-dilutive because adding shares to the denominator would make the loss per share smaller (less negative). Diluted EPS = basic EPS when there is a net loss.
Exam tip: CFA Level I loves giving you three securities and asking which ones are included in diluted EPS. Always rank by per-share impact and test sequentially. And remember: options with exercise price above market price are immediately excluded.
Practice anti-dilution problems in our CFA Level I question bank.
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