Earnings per Share

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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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There may be two EPS numbers for each item
Diluted
Basic
Reflects the maximum potential dilution from all
possible stock conversions that would have
decreased EPS.
Considers only common shares outstanding
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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 wed 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 only
• Other companies must report BOTH basic and
  diluted earnings per share
• It depends on whether the capital structure is
• Simple, or
• Complex

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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.
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Capital Structures
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)

• Page 109

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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

Page 109
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Step 1 find weighted average shares outstanding
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Step 1 find weighted average shares outstanding
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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

Page 109
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Stock Splits Dividends

• 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.

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Step 1 find weighted average shares outstanding
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Stock Splits Dividends

• This years 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
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Step 1 find weighted average shares outstanding
Multiply shares outstanding by fraction of year
and by split factor
Add em up
Make sure you have accounted for all 12 months
and no more than 12 months!
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Step 2 - numerator

• Net income 3,000,000
• Preferred dividends 10,000 shares 100
  6 60,000

Note Always include preferred dividend if it is
cumulative preferred stock. If not cumulative,
only include preferred dividend if declared
during year
Now lets plug everything into the formula . . .
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Step 3 compute basic EPS
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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 wed have to report both the basic EPS we
  computed plus a diluted earnings per share
  figure.

Page 111
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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

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Diluted Earnings per Share

• For convertible bonds and convertible preferred
  stock we use what is called the If Converted
  Method
• For options, we use the Treasury Stock Method

For 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, wed 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 8,000
• Common Shares Outstanding (entire year)
  6,000
• Stock Options Outstanding 2,000
• Exercise Price Per Share on Options 30
• Average Price of Common Shares 40

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Treasury Stock Method--Example
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Treasury Stock Method--Example 3 steps

1. Options assumed exercised (2,00030) 60,000
   cash received
2. Shares assumed repurchased with proceeds
   (60,000 / 40) 1,500
3. Additional shares assumed issued2,000 from
   exercise less 1,500 purchased with proceeds 500
   net new shares

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Treasury Stock Method--Example

8,000/6,500
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Short-cut formula
Net new shares Number of shares to which option holders are entitled Avg Mkt Price Option Price
Net new shares Number of shares to which option holders are entitled Avg Mkt Price
2,000
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) Weighted average of common shares assuming maximum dilution (including options) 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 share
4. 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.