ESOP Dilution: Reading Share-Based Costs and Diluted EPS in Results

A company can post a record quarter and still leave each shareholder with a slightly thinner slice than the headline suggests. ESOP dilution is one of the quiet reasons. Every employee stock option that is granted, vests and gets exercised adds shares to the pool, and the same profit then gets shared among more owners. The results table hints at this in one easy-to-miss line: diluted EPS.

We see plenty of investors read basic EPS, check the year-on-year growth and move on. That is fine for a mature business with few options outstanding. It is not fine for a company that pays a big part of staff pay in stock options. For those, the gap between basic and diluted EPS, and the option cost sitting inside expenses, deserve two minutes of your time.

What an ESOP actually is in India

In listed-company language, the scheme is usually called an ESOS, short for employee stock option scheme. The SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, in the version amended up to December 4, 2025, define it as a scheme under which a company grants employee stock options to employees, either directly or through a trust. The same rulebook also covers employee stock purchase schemes, stock appreciation rights, general employee benefit schemes, retirement benefit schemes and sweat equity shares. We covered that last one separately in our piece on sweat equity shares.

Three terms from the regulations matter for anyone reading results:

• Vesting is the process by which the employee becomes entitled to the benefit of a grant. The vesting period is the time over which that happens.
• Exercise is the employee applying to the company or the trust for shares against vested options.
• Exercise price is the price, if any, the employee pays to exercise. Regulation 17 leaves the company free to set this price, subject to the accounting policies in Regulation 15.

Regulation 18 sets a minimum vesting period of one year for an ESOS. There are two carve-outs. Options granted in place of options held in a merged or amalgamated company can count the time already served, and in the case of an employee’s death or permanent incapacity the one-year minimum does not apply.

Why should an investor care about the one-year floor? Because it tells you options granted this quarter cannot turn into shares within the next few quarters. A fresh grant is a future dilution, not an immediate one, and the diluted EPS line is the accounting tool that tries to show you that future early.

Two ways ESOP dilution hits shareholders

Option schemes touch your share of the profit through two separate doors, and they show up in different places in the results.

Door one: the expense. The global standard on this, IFRS 2 Share-based Payment, requires a company to reflect share-based payment transactions in its reported profit or loss, including expenses linked to share options granted to employees. In India, SEBI’s Regulation 15 tells companies running these schemes to follow the accounting standards notified by the Central Government under section 133 of the Companies Act, 2013, along with any Guidance Note on Accounting for employee share-based payments. So the cost of options granted is not a footnote. It reduces the profit line.

Door two: the share count. When vested options are exercised and new shares are issued, the denominator in EPS grows. Even before exercise, accounting asks the company to show what EPS would look like if dilutive options were exercised. That is diluted EPS.

For shares-settled options, the company keeps its cash. The cost doesn’t vanish, though. Existing shareholders pay it by owning a slightly smaller piece of the same business.

Some managements like to talk about “adjusted” profit that adds the option charge back because it is non-cash. That’s a choice worth questioning. If the business had paid those employees in cash instead, nobody would call the salary a one-off.

Basic EPS vs diluted EPS: the line to read

Basic EPS is simple: profit attributable to equity shareholders divided by the weighted average number of shares outstanding. Our explainer on EPS meaning in the share market walks through that part.

Diluted EPS adds potential shares. The IFRS Foundation’s summary of IAS 33 Earnings per Share describes dilution as a potential reduction in EPS (or potential increase in loss per share) that comes from assuming convertibles are converted, options or warrants are exercised, or shares are issued once specified conditions are met. It also says basic and diluted EPS must be presented with equal prominence. The share-based benefits regulations add an India-specific disclosure: under Part F of Schedule I, the board must disclose on the company’s website diluted EPS on issue of shares under all the schemes covered by the regulations.

As Investopedia’s diluted EPS explainer puts it, diluted EPS is the more conservative number. And a small difference between basic and diluted EPS signals that the company is less exposed to dilution.

How options get counted: the treasury stock method

Here’s the part that confuses people. If a company has 2 crore options outstanding, diluted EPS does not simply add 2 crore shares. Employees pay an exercise price when they exercise, and accounting assumes that cash is used to buy back shares.

The treasury stock method works like this. Only in-the-money options count, meaning those whose exercise price is below the market price. They are assumed to be exercised at the start of the period. The proceeds are assumed to repurchase shares at the average market price. The net new shares, assumed issued minus assumed repurchased, get added to the denominator.

So the dilution depends on how deep in the money the options are. Options with an exercise price close to the market price add very few net shares. Options with a tiny exercise price add almost their full count.

Worked example: Company A’s diluted EPS

All figures below are hypothetical and built only to show the arithmetic.

Company A reports quarterly profit attributable to shareholders of ₹120 crore. Its weighted average share count is 40 crore. It has 2 crore vested options outstanding with an exercise price of ₹60. The average market price for the quarter is ₹100.

Step 1: basic EPS. ₹120 crore ÷ 40 crore shares = ₹3.00.

Step 2: assumed exercise proceeds. 2 crore options × ₹60 = ₹120 crore.

Step 3: assumed buyback. ₹120 crore ÷ ₹100 average price = 1.2 crore shares.

Step 4: net new shares. 2 crore − 1.2 crore = 0.8 crore.

Step 5: diluted EPS. ₹120 crore ÷ (40 + 0.8) crore shares = ₹120 crore ÷ 40.8 crore ≈ ₹2.94.

Using the unrounded figure of ₹2.941, diluted EPS sits about 1.96% below basic EPS. Not dramatic, but not nothing either.

What changes when the stock runs up

Now keep everything the same, but say the average price for the quarter climbs to ₹150. The ₹120 crore of proceeds buys back only 0.8 crore shares, so net new shares rise to 1.2 crore. Diluted EPS becomes ₹120 crore ÷ 41.2 crore ≈ ₹2.91.

Notice the irony. The better the stock does, the more dilutive the same options become, because each rupee of exercise money buys back fewer shares. A rally can widen the basic-diluted gap even when management grants nothing new.

And when the options are underwater

If the average price falls to ₹50, below the ₹60 exercise price, the options are out of the money. Under the treasury stock method they are left out, so diluted EPS equals basic EPS at ₹3.00. The dilution hasn’t gone away for good. It is just parked until the price recovers.

A rising share price makes the same pile of options more dilutive. Track the gap between basic and diluted EPS over several quarters, not just one.

A zero-cost option, for comparison

Suppose instead the 2 crore options had an exercise price of just ₹1. Proceeds would be just ₹2 crore, buying back 0.02 crore shares at ₹100. Net new shares are 1.98 crore, and diluted EPS drops to ₹120 crore ÷ 41.98 crore ≈ ₹2.86. That’s a gap of about 4.7% from basic EPS, more than double the first case, with the same number of options.

Where to find the numbers in a results filing

You don’t need the annual report for a first read. Listed companies report both basic and diluted EPS, so the quarterly results statement is the first place to look. For the deeper picture, the regulations push companies to publish more. Part F of Schedule I asks the board to disclose, on the company website with a link in the board’s report, details such as:

• Each ESOS that existed during the year, including the number of options approved, vesting requirements, exercise price or pricing formula, maximum term and whether shares come from a fresh issue, the secondary market or both.
• Whether options are accounted for using the intrinsic value or the fair value method.
• If the intrinsic value method is used, the difference between that cost and what fair value would have produced, along with the impact on profits and on EPS.

That last disclosure is gold for a sceptical reader. It tells you how much rosier the profit looks because of the accounting method chosen.

Pair this with the employee cost line. Our guide to employee cost in quarterly results explains how to read that line against revenue. If employee cost jumps in a quarter with no matching jump in headcount, check the notes to see whether a large option grant explains it.

A five-point ESOP dilution checklist

1. Basic vs diluted EPS gap. Compute it as a percentage of basic EPS and track it for four to six quarters. A gap that keeps widening needs explaining.
2. Share count trend. Compare the weighted average share count year on year. Steady creep from exercises is dilution already delivered.
3. Option charge vs profit. Look for the share-based payment cost in the notes and divide it by reported profit. A business where this is a large share of profit is paying staff partly with your equity.
4. Exercise prices. Low or near-zero exercise prices mean almost every option becomes a net new share.
5. Trust purchases. The regulations allow schemes to run through a trust, and the board’s disclosure has to state whether shares come from a fresh issue, the secondary market or a combination. A scheme fed by market purchases may not raise the share count, so read which source applies before judging the dilution.

Does ESOP dilution make a stock a bad buy?

Not by itself. Stock options can keep good people and tie their pay to the share price, which is broadly what shareholders want. Plenty of well-run businesses use them sensibly.

The problem is only when investors ignore the cost. Valuing a company on basic EPS while its diluted EPS is several percent lower flatters the price-to-earnings multiple. Using diluted EPS as your default for P/E is the simple fix. If you’re building a fuller routine for reading results, our guide on how to analyse quarterly results of a company sets out where this check fits.

Quick recap

• ESOP dilution reaches shareholders through an expense in profit and loss and through a larger share count.
• SEBI’s 2021 regulations set a one-year minimum vesting period for an ESOS, with limited exceptions.
• Diluted EPS uses the treasury stock method for options: only in-the-money options count, and the exercise proceeds are assumed to buy back shares at the average market price.
• The higher the share price and the lower the exercise price, the bigger the dilution.
• Read the basic-diluted gap as a trend, and use diluted EPS for valuation.

Disclaimer: This article is for educational purposes only and is not investment advice. Company A and all profits, share counts, option numbers and prices in the worked example are hypothetical and used only to explain the calculation. Investments in the securities market are subject to market risks. Consult a SEBI-registered investment adviser before making investment decisions.