The If-Converted Method for Diluted EPS

Convertible bonds and convertible preferred stock can turn into common shares at the holder's option, so diluted EPS must ask: what would earnings and share count look like if that conversion had already happened? The if-converted method answers this by adding the new common shares to the share count and adding back whatever interest expense (net of tax) or preferred dividends the company would no longer owe.

The method is only applied when it is dilutive — that is, when it lowers EPS. If assuming conversion would actually raise EPS (an "antidilutive" result), the security is excluded from the diluted calculation entirely.

Worked example. A company has net income of $50 million and 20 million shares outstanding, plus a convertible bond paying $2 million of after-tax interest that converts into 4 million shares. Basic EPS is $50m / 20m = $2.50. Under if-converted, numerator becomes $50m + $2m = $52m and denominator becomes 20m + 4m = 24m, giving diluted EPS of $52m / 24m ≈ $2.17 — lower than basic, so the conversion is dilutive and must be included.

Analysts checking a company's own diluted EPS calculation should verify each convertible security is tested this way individually, since a company holding several convertibles at different conversion prices can have some dilutive and others not.