Earnings per Share

The Introductory Lecturefor Acct 592

The most closely watched statistic on Wall Street

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

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

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

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”

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

Common Stock

A simple capital structure consists of only common stock.

The corporation has only common and

nonconvertible preferred stock and has no convertible securities, stock

options, warrants, or other rights outstanding.

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

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

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.

Basic Earnings Per Share

Net Income - Preferred Dividends

Weighted average number of common shares outstanding

Earnings Per Share Example

A company has the following capital structure at the end of 2002: 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)

Page 109

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

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

4/1/2003 100,000 100,0004/1 to 6/29

6/30/20036/30 to 8/31

9/1/20039/1 to 12/31Weighted average

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

4/1/2003 100,000 100,0004/1 to 6/29 300,000 20,000 280,000 3/12

6/30/20036/30 to 8/31

9/1/20039/1 to 12/31Weighted average

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

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.

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 24/1/2003 100,000 100,000

4/1 to 6/29 300,000 20,000 280,000 3/12 26/30/2003 280,000 280,000

6/30 to 8/31 580,000 20,000 560,000 2/12 19/1/2003

9/1 to 12/31Weighted average

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 . . .

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

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 24/1/1999 100,000 100,000

4/1 to 6/29 300,000 20,000 280,000 3/12 26/30/1999 280,000 280,000

6/30 to 8/31 580,000 20,000 560,000 2/12 19/1/1999 -10,000 10,000

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

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 4/1/03 100,000 100,000

4/1 to 6/29 300,000 20,000 280,000 3/12 2 140,000 6/30/03 280,000 280,000

6/30 to 8/31 580,000 20,000 560,000 2/12 1 93,333 9/1/03 -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

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

Step 3 – compute basic EPS

Net income – Preferred dividendsWeighted average shares outstanding

$3,000,000 – $60,000513,333

$5.73

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.

Page 111

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

Diluted EPS

Diluted EPS = $4.89Both 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

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)

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 Method

Treasury Stock Method

Proceeds from conversion are assumed to be used for purchase of treasury stock at current market price.Treasury stock is assumed to be reissued to option or warrant holders.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.

Treasury Stock Method--Example: Basic Data

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

(entire year) 6,0001-for-1 Options Outstanding 2,000Exercise Price Per Share on Options$30Average Price of Common Shares $40Income Tax Rate 40%

Treasury Stock Method--Example

Basic EPS = $8,0006,000

$1.33Basic EPS =

Net income – Preferred dividendsWeighted average shares outstanding

Treasury Stock Method--Example: Option Proceeds

Options Assumed Exercised (2,000*30) = $60,000 cash “received”Shares Assumed Repurchased With

Proceeds ($60,000 / $40) = 1,500Additional Shares Assumed Issued:2,000 from exercise less 1,500 purchased with proceeds = 500 net new shares

Treasury Stock Method--Example:

Diluted EPS =$8,0006,000 + 500

=

$1.23Diluted EPS =

= $8,000/6,500 =

Net income – Preferred dividendsWeighted average shares outstanding

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.