The Impact of ESOPs on Diluted EPS: What Every Founder (and Investor) Should Understand

Earnings Per Share (EPS) is one of the most closely watched metrics in financial statements. It directly influences valuation multiples, investor perception, and market confidence.

However, EPS is not just a function of profitability; it is also shaped by capital structure decisions. One of the most significant (and often misunderstood) contributors to EPS dilution is Employee Stock Option Plans (ESOPs).

This blog explains how ESOPs affect diluted EPS, why this matters to investors, and what accounting standards require companies to disclose.

Understanding EPS: Basic vs Diluted

1. Basic EPS

Basic EPS measures the portion of a company’s profit attributable to each outstanding equity share based only on existing shares.

It ignores any instruments that could convert into shares in the future and is calculated using the weighted average number of shares outstanding during the period. Basic EPS is useful but incomplete.

2. Diluted EPS

Diluted EPS answers a more conservative question:

What would EPS look like if all potentially dilutive securities were converted into equity shares?

These potential equity instruments include:

• Employee Stock Options (ESOPs)

• Warrants

• Convertible debt or preference shares

Because it reflects a worst-case ownership and earnings scenario, investors and analysts typically rely more on diluted EPS than basic EPS.

Why Diluted EPS matters to investors?

Diluted EPS provides a more realistic picture of:

• Future ownership dilution

• Sustainable earnings per share

• True valuation multiples (P/E ratios)

A company with strong basic EPS but significantly lower diluted EPS is effectively signalling future dilution risk, something long-term investors cannot ignore.

When are esops considered dilutive?

Under AS 20 (Para 37) and Ind AS 33 (Para 46), ESOPs are considered dilutive only when they are “in the money.”

That is:

• Exercise price < Average market price during the reporting period

Such options are assumed to be exercised because doing so is economically rational for employees. This increases the number of outstanding shares and dilutes EPS.

If the exercise price is higher than or equal to the market price, the options are treated as anti-dilutive and excluded from diluted EPS calculations.

How esops create dilution?

ESOPs grant employees the right (not the obligation) to purchase shares at a pre-determined price after vesting.

When options are exercised:

• New shares are typically issued

• Total outstanding shares increase

• Existing shareholders’ ownership percentage reduces

• Earnings are spread over a larger base → EPS declines

Importantly, diluted EPS anticipates this dilution. It does not wait for actual exercise to occur.

Treasury stock method: Calculating esop impact on Diluted EPS

Accounting standards use the Treasury Stock Method to compute dilution from ESOPs.

1. Step 1: Identify in-the-money options - Only options with exercise prices below the market price are included.

2. Step 2: Assume all such options are exercised - Example:

• Number of options: 1,000,000, Exercise price: ₹10

→ Assumed new shares issued: 1,000,000

3. Step 3: Calculate exercise proceeds - 1,000,000 × ₹10 = ₹10,000,000

4. Step 4: Assume share buyback using proceeds - If market price = ₹25: ₹10,000,000 ÷ ₹25 = 400,000 shares

5. Step 5: Determine net incremental shares - 1,000,000 − 400,000 = 600,000 shares. These 600,000 shares are added to the denominator for diluted EPS.

Numerical illustration

Assumptions:

• Net income: $50 million

• Weighted average basic shares: 10 million

• In-the-money ESOPs: 1 million

• Exercise price: $10

• Market price: $25

Basic EPS

• $50 million ÷ 10 million = $5.00

Diluted EPS

• Incremental shares (Treasury Stock Method): 600,000

• Diluted shares: 10.6 million

• $50 million ÷ 10.6 million = $4.72

Impact

• EPS reduction: $0.28 (≈ 5.6%)

When esops do not reduce Diluted EPS?

1. Out-of-the-Money Options

If exercise price ≥ market price:

• Options are anti-dilutive

• Excluded from diluted EPS

2. Loss-Making Periods

If a company reports a net loss:

• Including potential shares would reduce loss per share artificially

• Accounting standards prohibit this

Hence, all potential equity instruments are excluded from diluted EPS during loss periods.

Disclosure requirements: Who must report EPS?

Listed and Unlisted Companies where IND AS and Accounting Standards are applicable need to disclose EPS  

Why this matters

• For investors: Diluted EPS reflects the true earnings capacity per share and directly impacts valuation multiples.

• For companies: Transparent ESOP accounting builds credibility with investors and analysts.

• For employees: Understanding dilution helps place ESOP wealth creation in a broader ownership context.

Conclusion

ESOPs are a powerful tool for talent retention and long-term alignment, but they come with measurable financial consequences. Diluted EPS captures the true economic cost of equity compensation, combining both accounting expense and ownership dilution.

For investors, founders, and boards alike, understanding this impact is essential for making informed decisions and communicating performance transparently.