Chartered Financial Analyst (CFA) Level 1 Practice Exam

What does Diluted Earnings Per Share (EPS) account for?

1. The potential dilution of shares from conversions and options

2. Only the currently outstanding shares

3. Preferred dividends but not common shares

4. The shares that could be exchanged during the company's debt repayment

The correct answer is: The potential dilution of shares from conversions and options

Diluted Earnings Per Share (EPS) specifically accounts for the potential dilution of existing shares that could occur if securities such as convertible bonds, stock options, or warrants are exercised or converted into common shares. This metric provides a more conservative view of a company’s profitability by reflecting the impact of such conversions on the total number of shares outstanding. In practice, diluted EPS is calculated by adjusting the net income and the number of shares outstanding to include these potentially dilutive securities. This is vital for investors as it offers a more realistic picture of earnings per share that shareholders may actually receive, unlike basic EPS, which only considers currently outstanding shares. This distinction is essential, especially in assessing the value and profitability of companies that may issue various forms of convertible or dilutive securities. The other options do not encapsulate the full scope of diluted EPS. For example, accounting only for currently outstanding shares neglects the potential impact of additional shares coming onto the market, which is central to the purpose of diluted EPS. Similarly, focusing solely on preferred dividends or debt repayment shares does not address the broader implication of potential share dilution.