Impacts on EPS and Ownership Dilution

Understanding How Share-Based Compensation Affects Ownership

It’s kind of funny—when I was novice in finance, I thought share-based compensation was just like handing out free stocks, no big deal. But oh boy, I soon realized how complicated its influence on a company’s Earnings Per Share (EPS) really is. And, of course, there’s the not-so-tiny matter of diluting existing shareholders. Whether you’re awarding options to upper management or allowing rank-and-file employees to participate in an employee stock purchase plan (ESPP), these actions can change the total share count and push EPS down. In this discussion, we’ll untangle this complexity, step by step.

The Basic Idea of EPS and Dilution

Before we dive into the specifics of how options, restricted stock, and other share-based awards affect EPS, let’s do a quick refresher on definitions:

• Basic EPS is essentially:

$$ \displaystyle \text{Basic EPS} ;=; \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted Average Number of Common Shares Outstanding}} $$

This formula has no bells or whistles. It just takes the net income available to common shareholders and divides it by the weighted average of shares outstanding during the period.

• Diluted EPS is a “worst-case scenario” measure. It counts not only the current shares but also potential shares—like in-the-money stock options, warrants, or convertible securities—that could become actual shares if exercised or converted. So:

$$ \displaystyle \text{Diluted EPS} ;=;\frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted Avg. Shares Outstanding + Shares from Conversion/Exercisable Options}} $$

Dilution refers to how these potential shares reduce current shareholders’ ownership percentage (and often reduce per-share earnings). In other words, if the pie (net income) remains the same but the number of slices (shares) increases, each slice becomes smaller.

The Treasury Stock Method

The Treasury Stock Method is our standard go-to technique for determining the incremental shares from stock options or warrants. The idea is straightforward:

1. Assume that in-the-money stock options are exercised at their strike price, generating hypothetical proceeds for the company.
2. The company uses those hypothetical proceeds to buy back shares at the current market price.
3. The net difference in shares (issued minus the shares repurchased) is added to the denominator for diluted EPS.

Let’s visualize the logic in a flowchart:

    flowchart TB
	    A["Start <br/>EPS Calculation"]
	    B["Identify <br/>Options"]
	    C["Are options <br/>In-The-Money?"]
	    D["Incremental <br/>Shares Added"]
	    E["No effect on <br/>Diluted EPS"]
	
	    A --> B
	    B --> C
	    C -- "Yes" --> D
	    C -- "No" --> E

Now, if options are out-of-the-money, you can just skip them for diluted EPS (they won’t dilute if no one would realistically exercise them).

In-the-Money vs. Out-of-the-Money

• In-the-Money (ITM): If the exercise price is below the current market price for a call option, it has intrinsic value. In that case, we reasonably assume they will be exercised, so include them in diluted EPS.

• Out-of-the-Money (OTM): If the exercise price is above the current market price for a call option, there’s no intrinsic value. Typically, these are excluded from the diluted EPS calculation because it’s not logical for holders to exercise an option that would cause them to overpay for the stock.

A Quick Python Example

Here’s a short Python snippet that calculates the net incremental shares from an option plan using the Treasury Stock Method. It might come in handy if you love seeing the math in code:

 1# 5,000 stock options with a strike of $8, and current market price of $10.
 2shares_out = 50000
 3option_shares = 5000
 4strike_price = 8
 5current_market_price = 10
 6
 7proceeds = option_shares * strike_price  # 5000 * 8 = 40,000
 8
 9shares_repur = proceeds / current_market_price  # 40,000 / 10 = 4,000
10
11net_new_shares = option_shares - shares_repur  # 5000 - 4000 = 1000
12
13diluted_shares = shares_out + net_new_shares   # 50,000 + 1,000 = 51,000
14
15print("Diluted shares outstanding =", diluted_shares)

Restricted Stock and RSUs

Restricted Stock and Restricted Stock Units (RSUs) can affect EPS in a more nuanced way. Generally:

• Basic EPS only includes shares that have vested (i.e., fully earned by employees). If these are not vested yet, they’re not taken as common shares in the basic EPS denominator.
• For Diluted EPS, unvested shares might be included if they are considered likely to vest based on service or performance conditions. Different standards might require you to look into the degree of certainty about vesting.

In practice, if there are restrictions and certain performance hurdles are not yet met, those shares remain out of the picture. But once the vesting conditions are basically unstoppable or the employee has completed the required service, you include them.

Employee Stock Purchase Plans (ESPPs)

Companies sometimes offer discounted purchase plans to employees—like “buy shares at a 10% discount from the market price.” These shares can also generate incremental share counts for diluted EPS. If the discount is large enough, employees effectively get a bargain, and that difference can be considered part of share-based compensation.

The formula typically examines the discount from the market price and calculates the incremental shares similarly to the Treasury Stock Method. In many cases, if the discount is small, the incremental impact might be minimal, but occasionally it’s large enough to matter.

Putting It All Together: A Step-by-Step Example

Let’s pretend we have the following scenario for the year ended December 31:

• Net income available to common shareholders: $1,000,000
• Weighted average common shares outstanding (basic): 200,000
• 10,000 stock options with a strike price of $20 (all ITM), current market price: $25
• 5,000 shares of restricted stock that vested on December 31, but the service condition ended October 1, meaning employees essentially earned it at that date for weighting.
• No other potentially dilutive securities.

Calculating Basic EPS

Well, that’s easy:

$$ \text{Basic EPS} = \frac{1{,}000{,}000}{200{,}000} = $5.00 \text{ per share.} $$

Calculating the Incremental Shares from the Options

• Proceeds = 10,000 × $20 = $200,000
• Repurchase = $200,000 ÷ $25 = 8,000 shares
• Incremental shares = 10,000 – 8,000 = 2,000

Incorporating Restricted Stock

These 5,000 restricted shares vested on December 31, but if they were effectively earned (service condition completed) already on October 1, they might be included in the weighted average share calculation for the final quarter. For simplicity, let’s assume they only count from the date they vested, so the weighting is tricky. Suppose you approximate an additional 1,250 shares for the year’s average (this is a simplified stance, but it demonstrates the principle).

New Diluted Share Count

• Basic shares: 200,000
• Incremental from options: 2,000
• Incremental from restricted shares (weighted portion): 1,250
• Total shares for Diluted EPS: 203,250

Diluted EPS

$$ \text{Diluted EPS} = \frac{1{,}000{,}000}{203{,}250} \approx $4.92\text{ per share.} $$

Notice how it dropped from $5.00 to about $4.92 after factoring in the incremental shares. That’s the essence of dilution.

Managing Compensation Plan Size and Structure

From a managerial perspective, no CEO wants to watch their EPS take a nosedive just because of share-based compensation. It’s not necessarily that they dislike compensating employees, but it’s about balancing the cost of awarding more potential shares versus retaining and motivating talent. Also, public companies know that analysts track EPS closely and can react negatively to large EPS hits from share-based compensation.

Thus, managers strategize on:

• The strike prices for options.
• The mixture of restricted stock vs. stock options.
• Vesting periods and performance hurdles.

Aligning incentives for the long term while minimizing undue EPS dilution can be a fine art. You can see how this leads to lively boardroom discussions.

Footnote Disclosures and Vignette Clues

When analyzing a company’s financials—or reading a CFA vignette—always dig into the footnotes in the financial statements. That’s usually where they’ll hide details like:

• The assumptions used for option pricing (e.g., volatility, expected term).
• How many options are in-the-money vs. out-of-the-money.
• The discount on ESPP shares.
• The vesting schedule for restricted stock and RSUs.

CFA exam vignettes often revolve around these footnotes. You’ll likely be asked to compute the correct diluted EPS figure for a scenario or to explain how unvested awards are treated. Pay close attention to the timeline for vesting and the market price vs. exercise price.

Another ESPP Calculation Example

Let’s do a smaller-scale example of an ESPP:

• 1,000 employees, each allowed to buy 2 shares per quarter, or 8,000 shares total per year at a 15% discount to the market price.
• The market price averages $40 for the year, so the purchase price is $34. (15% discount from $40).
• Proceeds from ESPP = 8,000 × $34 = $272,000
• Shares that can be repurchased at $40 = $272,000 ÷ $40 = 6,800
• Incremental shares = 8,000 – 6,800 = 1,200

Now those 1,200 shares get tacked on for diluted EPS. Admittedly, that’s not a huge number relative to the total, but in bigger companies, this might be tens of thousands of shares or more.

Common Pitfalls

• Forgetting to exclude out-of-the-money options—this can lead to overestimating dilution.
• Failing to notice that certain restricted stock is not yet vested.
• Mixing up the timing on partial-year vesting.
• Overlooking employee stock purchase plans that might have small but material incremental shares.
• Misreading footnotes on performance-based awards that only vest if specific targets are reached.

Additional Perspective: IFRS and US GAAP

Under both IFRS (particularly IFRS 2 for share-based payments) and US GAAP (ASC 718 for accounting, ASC 260 for EPS), the fundamental idea is the same: measure the potential dilutive effect of share-based arrangements. Detailed rules differ slightly in how certain performance or market conditions are treated, but from an exam perspective, you’d likely focus on the universal concepts of Basic EPS vs. Diluted EPS, the treasury stock method, and how vested vs. unvested awards are handled.

References

• CFA Institute, 2024/2025 Level II Curriculum, “Earnings Per Share Analysis with Share-Based Compensation.”
• KPMG, “Accounting for Share-Based Payments,” especially the sections on EPS and dilution examples.
• Financial Accounting Standards Board (FASB) ASC 260, “Earnings Per Share.”
• IFRS 2, “Share-based Payment,” for global standards.

Test Your Knowledge: EPS and Ownership Dilution Quiz