Earnings Per Share (EPS)

1
Earnings Per Share (EPS)

• RCJ Chapter 15 (836-842)

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Key Issues

1. Basic EPS 
2. Weighted average common shares
3. Pecking order
4. Treasury stock transactions
5. Dilution
6. Diluted EPS
7. options and warrants treasury stock method
8. Convertible bonds and preferred stock if
   converted method
9. Determining dilution vs anti-dilution

3
Basic EPS

• weight shares outstanding by fraction of year
• changes due to share repos, issuances, option
  exercises, etc.. 

4
Basic EPS - Example

• On January 1, 2001 Solomon Corporation had
• 160,000 common shares outstanding.
• 10,000 preferred shares, 100 par value, 7
• On September 1, 2001 the company issued 40,000
  additional common shares.
• The net income for 2001 1,257,331
• What is the basic EPS?

Preferred dividends 10,000 x 100 x0.07 70,000
5
Basic EPS (contd)

• EPS is from common shareholders viewpoint
• Pecking order of suppliers of capital
• Debt holders
• Preferred stock holders
• Common stock holders
• Why are preferred dividends subtracted, but not
  bond interest?
• Ex. E15-14 P15-4

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Effect of Treasury Stock Transactions

• 1. Purchase of treasury shares
• DR Treasury stock (contra O/E A/C)
  CR Cash
• 2. resale of treasury shares
• DR Cash
• DR APC
• CR Treasury stock (at cost, from 1.)
• CR APC
• DR (or CR) to APC is economic loss (or gain)
  that is not recognized in accounting

or
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Effect of Treasury Stock Transactions (contd)

• Key point
• Transactions in own common stock dont affect NI
  (proprietary viewpoint), only affect number of
  shares outstanding so firms can manipulate EPS
• QHow does transaction timing during the year
  affect EPS? 
• Ex. E15-16 P15-8

8
Diluted EPS

• SFAS No. 128 requires companies with complex
  capital structures to compute another measure
  called diluted earnings per share.
• (1) Options and (2) Convertible securities can
• Decrease EPS ? dilutive
• Increase EPS ? anti-dilutive

Income adjustments due to dilutive financial
instruments
Net income
- Preferred dividends
Diluted EPS
Newly issuable shares due to dilutive financial
instruments
Weighted average number of common shares
outstanding

Only dilutive securities are included in the
diluted EPS calculation
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Conversion Ratio
Income adjustments due to dilutive financial
instruments
Conversion ratio
Newly issuable shares due to dilutive financial
instruments

• The dilutive effect of financial instruments (for
  example, options warrants, and convertible bonds)
  on EPS is calculated starting with the instrument
  with the lowest conversion rate (i.e. most
  dilutive), and working up to the instrument with
  the highest conversion rate (i.e. least dilutive).

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Step 1 calculate the effect of options and
warrants on EPS

• Treasury Method

Q Option exercise price lt Market price
No
Yes
Options have dilutive effect ? include them in
diluted EPS 1. Assume all options are exercised
? add new shares. 2. Assume proceeds ( shares x
exercise price) are used to repurchase previously
issued common shares ? subtract these shares.
Options do not have dilutive effect ? not
included in diluted EPS.
11

• Example Now assume that Solomon Corporation
  issued options to buy 20,000 shares of common
  stock at 100 per share. The market price is
  114. What is the diluted EPS?

• Option exercise price 100 lt Market price 114
• Upon full exercise of option ? additional 20,000
  shares
• The proceeds 20,000 X 100 2,000,000
• are assumed to be used to repurchase previously
  issued common shares at the 114 market price.
• The dilution effect 20,000 17,544 2,456
  shares

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Step 2 calculate effect of convertible
securities on EPS

• if-converted method (one convertible security)
• Increase in EPS denominator calculate additional
  shares under full conversion.
• Increase in EPS numerator Calculate increase in
  net income if interest had not been paid on the
  convertible bonds/preferred shares.

Conversion ratio
Yes
No
Dilutive effect Add increase in numerator and
Denominator to Dilutive EPS.
No dilutive effect leave Dilutive EPS after step
1 as-is.
13

• Example cont Solomon Corporation also has
• 1,000,000 of 5 convertible bonds, with par
  (face) value of 1,000 per bond
• Each 1,000 bond pays interest of 50 per year
  and is convertible into 10 shares of common
  stock.
• 35 tax rate
• What is the dilutive EPS now?

• Increase in denominator 1,000 x 10 10,000
  shares
• Increase in numerator 1000 x 50 x
  (1-0.35)32,500

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Summary of example
Basic EPS 6.85 (slide 4)
1. After considering effect of options 6.75
(slide 11)
2. After considering effect of convertible bonds
6.57 (slide 13)
Q Why does dilution effect of options always
come before convertibles?
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If converted method with multiple convertible
securities
Rank all convertible securities by conversion
ratio take convertible with lowest conversion
ratio
For the chosen convertible security check
Yes Dilutive
No Anti-dilutive
Calculate New EPS
Stop
Take the convertible with the next lowest
conversion ratio
Options have lower conversion ratio, therefore
come before convertibles.
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Exercises

• E15-14
• P15-4
• P15-12