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Earnings per Share

The Introductory Lecturefor Acct 414

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The most closely watched statistic on Wall Street

Earnings per share (EPS) is an important indicator of the success or failure of a company.

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Several components of EPS must be disclosed if there are discontinued operations, extraordinary items, or cumulative effects of changes in accounting principles.

Earnings Per Share: Continuing operations $3.15 Discontinued operations .67 Extraordinary loss (.15) Cumulative effect of accounting change .17 Net Earnings Per Share $3.84

Cumulative effect item pretty much “gone” after SFAS No. 154

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Reflects the maximum

potential dilution from all possible

stock conversions that

would have decreased EPS.

Diluted

There may be two EPS numbers for each item:

Considers onlycommon shares

outstanding

Basic

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Relation between Basic and Diluted EPS

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Diluted earnings per share

I like to think of it as the

‘worst case scenario’

It is the lowest possible number we’d report for EPS It is a “proforma” number, not a “fact”

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Capital structure determines reporting

Many companies will report basic earnings per share onlyOther companies must report BOTH basic and diluted earnings per shareIt depends on whether the capital structure is

Simple, orComplex

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Common Stock

A simple capital structure consists of just common stock.

The corporation has only common and

nonconvertible preferred stock.

It has no convertible securities, stock

options, warrants, or other rights outstanding.

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Capital Structures

Complex Capital Structure: The

corporation has one or more instruments

outstanding that could result in issuance of

additional common shares.

Complex Capital Structure: The

corporation has one or more instruments

outstanding that could result in issuance of

additional common shares.Convertible Preferred

Stock Options

Convertible Bonds

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Capital StructuresTherefore, a company

with potential per share dilution is

considered to have a complex capital

structure.

Therefore, a company with potential per share dilution is

considered to have a complex capital

structure.

Note that a potentially dilutive security does not necessarily dilute EPS

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Dilution of Earnings

Dilutive Securities: Securities whose assumed exercise or conversion results in a reduction in earnings per share.Antidilutive Securities: Securities whose assumed conversion or exercise results in an increase in earnings per share.

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Basic Earnings Per Share

Net Income - Preferred Dividends

Weighted average number of common shares outstanding

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Earnings Per Share Example

A company has the following capital structure at the end of 2006: 6% Cumulative preferred stock, $100 par

value, issued and outstanding 10,000 shares

Common stock, $10 par, issued 200,000 shares, outstanding 180,000 shares

Treasury stock (20,000 shares at cost of $18)

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EPS Example

During 2006, the following transactions take place: April 1, 2006 – issued 100,000 shares to

acquire the assets of another company. Market value of shares was $25

June 30, 2006 – declared and distributed a 2 for 1 stock split effected in the form of a stock dividend

September 1, 2006 – sold 10,000 shares of the treasury stock for $28 per share

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Step 1 – find weighted average shares outstanding

DateCommon

StockTreasury

Stock

Common Shares

OutstandingMonths

Split Factor

Weighted

1/1 to 3/31 200,000 20,000 180,000 3/12

4/1/2006 100,000 100,0004/1 to 6/29

6/30/20066/30 to 8/31

9/1/20069/1 to 12/31Weighted average

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Step 1 – find weighted average shares outstanding

DateCommon

StockTreasury

Stock

Common Shares

OutstandingMonths

Split Factor

Weighted

1/1 to 3/31 200,000 20,000 180,000 3/12

4/1/2006 100,000 100,0004/1 to 6/29 300,000 20,000 280,000 3/12

6/30/20066/30 to 8/31

9/1/20069/1 to 12/31Weighted average

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EPS Example

During 2006, the following transactions take place: April 1, 2006 – issued 100,000 shares to

acquire the assets of another company. Market value of shares was $25

June 30, 2006 – declared and distributed a 2 for 1 stock split effected in the form of a stock dividend

September 1, 2006 – sold 10,000 shares of the treasury stock for $28 per share

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Stock Splits & DividendsAll stock splits and stock dividends must be incorporated into the computation of weighted average shares outstanding.

All stock splits and stock dividends must be incorporated into the computation of weighted average shares outstanding.

This must done for all periods presented in the financial statements.

This must done for all periods presented in the financial statements.

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Step 1 – find weighted average shares outstanding

DateCommon

StockTreasury

Stock

Common Shares

OutstandingMonths

Split Factor

Weighted

1/1 to 3/31 200,000 20,000 180,000 3/12 24/1/2006 100,000 100,000

4/1 to 6/29 300,000 20,000 280,000 3/12 26/30/2006 280,000 280,000

6/30 to 8/31 580,000 20,000 560,000 2/12 19/1/2006

9/1 to 12/31Weighted average

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Stock Splits & Dividends

This year’s EPS figures may have to be changed in the future as a result of stock splits or dividends.Think about what would happen if we did NOT make the adjustment . . .

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EPS Example

During 2003, the following transactions take place: April 1, 2003 – issued 100,000 shares to

acquire the assets of another company. Market value of shares was $25

June 30, 2003 – declared and distributed a 2 for 1 stock split effected in the form of a stock dividend

September 1, 2003 – sold 10,000 shares of the treasury stock for $28 per share Page 109

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Step 1 – find weighted average shares outstanding

DateCommon

StockTreasury

Stock

Common Shares

OutstandingMonths

Split Factor

Weighted

1/1 to 3/31 200,000 20,000 180,000 3/12 24/1/2006 100,000 100,000

4/1 to 6/29 300,000 20,000 280,000 3/12 26/30/2006 280,000 280,000

6/30 to 8/31 580,000 20,000 560,000 2/12 19/1/2006 -10,000 10,000

9/1 to 12/31 580,000 10,000 570,000 4/12 1Weighted average 12/12

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Step 1 – find weighted average shares outstanding

DateCommon

StockTreasury

Stock

Common Shares

OutstandingMonths

Split Factor

Weighted

1/1 to 3/31 200,000 20,000 180,000 3/12 2 90,000 4/1/2006 100,000 100,000

4/1 to 6/29 300,000 20,000 280,000 3/12 2 140,000 6/30/2006 280,000 280,000

6/30 to 8/31 580,000 20,000 560,000 2/12 1 93,333 9/1/2006 -10,000 10,000

9/1 to 12/31 580,000 10,000 570,000 4/12 1 190,000 Weighted average 12/12 513,333

Multiply shares outstanding by fraction

of year and by split factor

Make sure you have accounted for all 12

months and no more than 12 months!

Add ‘em up

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Step 2 - numerator

Net income = $3,000,000

Preferred dividends =

10,000 shares * $100 * 6% = $60,000

Now let’s plug everything into the formula . . .

Note: Always include preferred dividend if it is cumulative preferred stock. If not cumulative, only include preferred dividend if declared during year

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Step 3 – compute basic EPS

Net income – Preferred dividendsWeighted average shares outstanding

$3,000,000 – $60,000513,333

$__________

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What if . . .

Taking the same facts, what if the preferred stock was convertible into 10 shares of common stock at the option of the stockholder? This would make it a “complex capital

structure” and we’d have to report both the basic EPS we computed plus a “diluted earnings per share” figure.

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Convertible preferred

The 10,000 shares of preferred could become 100,000 shares of common stock (outstanding all year)We would NOT pay the preferred dividend because there would be no preferred stock

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Diluted EPS

Diluted EPS = $__________Both the $5.73 and the $4.89 would be reported on the face of the income statement

$3,000,000 – $0513,333 + 100,000

Net income – Preferred dividendsWeighted average shares outstanding

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Diluted Earnings per Share

For convertible bonds and convertible preferred stock we use what is called the

If Converted MethodFor options, we use the

Treasury Stock MethodFor computing dilution, the rate of conversion most advantageous to the security holder is used (maximum dilutive conversion rate)

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The If-Converted Method

The conversion of the securities into common stock is assumed to occur at the beginning of the year or date of issue, if later.Convertible bonds: The interest expense (net of tax) is added back to net income.Convertible preferred: No deduction for preferred dividends.The weighted average number of shares is increased by the additional common shares assumed issued.

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Treasury Stock Method

Proceeds from conversion are assumed to be used for purchase of treasury stock at AVERAGE market price. Purpose is to acquire treasury stock that

can be reissued to option or warrant holders. If not sufficient, we’d have to issue MORE shares

Any additional shares issued, over treasury stock, are added to “weighted- average shares outstanding.” Exercise is assumed to occur on the first

day of the year unless issue date is later.

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Treasury Stock Method--Example: Basic Data

Assume the following:Net Income $8,000Common Shares Outstanding

(entire year) 6,000

Stock Options Outstanding 2,000Exercise Price Per Share on Options$30Average Price of Common Shares $40

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Treasury Stock Method--Example

Basic EPS = $8,0006,000

$1.33Basic EPS =

Net income – Preferred dividendsWeighted average shares outstanding

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Treasury Stock Method--Example: 3 steps

1. Options assumed exercised (2,000*30) = $60,000 cash “received”

2. Shares assumed repurchased withproceeds ($60,000 / $40) =

1,5003. Additional shares assumed issued:

2,000 from exercise less 1,500 purchased with proceeds = 500 net new shares

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Treasury Stock Method--Example:

Diluted EPS =$8,0006,000 + 500

=

$1.23Diluted EPS =

= $8,000/6,500 =

Net income – Preferred dividendsWeighted average shares outstanding

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Short-cut formula:

Net new

shares =

Number of shares to

which option holders

are entitled

*

Avg Mkt Price – Option Price

Avg Mkt Price

2,000 *

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Formula for diluted EPS

Net income

- Preferred dividends if preferred stock is

NOT convertible

+ After-tax bond interest on conver-tible bonds

Weighted average of common shares assuming maximum dilution

(including options)

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Getting the lowest possible number – an algorithm

1. Compute the per share effect of each potentially dilutive security separately.

2. Make a list from smallest per share number to largest per share number

3. Compute basic earnings per share4. For diluted EPS, take the securities

into EPS computation one at a time until the next item on the list is bigger than the most recent EPS figure.