How do I calculate diluted EPS using the treasury stock method and if-converted method?

Diluted EPS accounts for all potentially dilutive securities -- stock options, warrants, convertible bonds, and convertible preferred stock. It shows the worst-case EPS if everything were converted.

Basic EPS = (Net Income - Preferred Dividends) / Weighted Average Shares Outstanding

Diluted EPS uses two methods:

1. Treasury Stock Method (for Options and Warrants)

Assumes options are exercised and the company uses proceeds to buy back shares at the average market price.

Example -- Ridgeline Tech:

• Net income: $10,000,000
• Weighted average shares: 2,000,000
• Options outstanding: 200,000 at exercise price $30
• Average market price: $50

Steps:

1. Shares from exercise: 200,000
2. Cash received: 200,000 x $30 = $6,000,000
3. Shares repurchased: $6,000,000 / $50 = 120,000
4. Net new shares: 200,000 - 120,000 = 80,000

Basic EPS = $10M / 2M = $5.00

Diluted EPS = $10M / (2M + 80K) = $4.81

Important: If the exercise price > market price, the options are anti-dilutive (out of the money) and are excluded from diluted EPS.

2. If-Converted Method (for Convertible Bonds and Preferred)

Assumes the convertible security was converted at the beginning of the period.

Example -- Ridgeline also has $5M in convertible bonds, 4% coupon, convertible into 150,000 shares. Tax rate: 25%.

Adjustments:

1. Add back interest saved (net of tax): $5M x 4% x (1 - 0.25) = $150,000
2. Add converted shares: 150,000

Diluted EPS = ($10M + $150K) / (2M + 80K + 150K) = $10,150,000 / 2,230,000 = $4.55

Anti-Dilution Check: For each convertible, calculate the per-share impact:

$150,000 / 150,000 = $1.00 per share

Since $1.00 < basic EPS of $5.00, the conversion is dilutive and must be included. If the per-share impact exceeded basic EPS, the security would be anti-dilutive and excluded.

Exam Tip: Always test for anti-dilution. Include the most dilutive securities first, then add the next most dilutive, stopping when the next security would be anti-dilutive.

Practice diluted EPS calculations in our CFA Level I question bank.