Calculating Diluted Earnings Per Share with Stock Options

This example illustrates how to calculate diluted earnings per share (EPS) for a company with outstanding stock options.

Scenario:

Marigold Corp. had the following stock activity in 2018:

1,000,000 shares of common stock outstanding at December 31, 2017.* 1,000,000 additional shares issued for cash on July 1, 2018.* Stock options outstanding at the beginning and end of 2018 allowing holders to purchase 306,000 shares of common stock at $21 per share.* The average market price of Marigold's common stock during 2018 was $28.

Calculation:

To compute diluted EPS, we need to consider the potentially dilutive effect of the stock options. Here's the breakdown:

Shares outstanding before considering stock options: * 1,000,000 (beginning) + 1,000,000 (issued) = 2,000,000 shares
Impact of stock options: * Since the average market price ($28) is higher than the exercise price ($21), the stock options are dilutive. * Additional shares from options = (Exercise price / Average market price) * Number of stock options * Additional shares = ($21 / $28) * 306,000 = 229,500 shares
Diluted shares outstanding: * 2,000,000 (total shares) + 229,500 (additional shares) = 2,229,500 shares

Therefore, the number of shares to be used in computing diluted earnings per share for 2018 is 2,229,500.

Key Takeaway:

Diluted EPS provides a more conservative view of a company's earnings per share by considering the potential dilution from outstanding securities like stock options.