Earnings per Share

The Introductory Lecture for Acct 414

The most closely watched statistic on Wall Street

Earnings per share (EPS) is an important indicator of the success or failure of a company.
2

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

There may be two EPS numbers for each item:

Basic
Considers only common shares outstanding

Diluted
Reflects the maximum potential dilution from all possible stock conversions that would have decreased EPS.
4

Relation between Basic and Diluted EPS

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
6

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

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.
8

Common Stock

Capital Structures
Complex Capital Structure: The corporation has one or more instruments outstanding that could result in issuance of additional Convertible common shares.
Preferred

Convertible Bonds

Stock Options

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
10

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.
11

Basic Earnings Per Share

Net Income - Preferred Dividends Weighted average number of common shares outstanding

12

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) 13

Page

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
14

Step 1 find weighted average shares outstanding

Common Shares Outstanding 20,000 180,000 100,000

Date 1/1 to 3/31 4/1/2006 4/1 to 6/29 6/30/2006 6/30 to 8/31 9/1/2006 9/1 to 12/31
Weighted average

Common Stock 200,000 100,000

Treasury Stock

Months
3/12

Split Factor

Weighted

15

Step 1 find weighted average shares outstanding

Common Shares Outstanding 20,000 180,000 100,000 20,000 280,000

Date 1/1 to 3/31 4/1/2006 4/1 to 6/29 6/30/2006 6/30 to 8/31 9/1/2006 9/1 to 12/31
Weighted average

Common Stock 200,000 100,000 300,000

Treasury Stock

Months
3/12 3/12

Split Factor

Weighted

16

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
17

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.
18

Step 1 find weighted average shares outstanding

Date 1/1 to 3/31 4/1/2006 4/1 to 6/29 6/30/2006 6/30 to 8/31 9/1/2006 9/1 to 12/31
Weighted average

Common Stock 200,000 100,000 300,000 280,000 580,000

Treasury Stock

Common Shares Outstanding 20,000 180,000 100,000 20,000 280,000 280,000 20,000 560,000

Months
3/12 3/12 2/12

Split Factor 2 2 1

Weighted

19

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 . . .
20

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
21

Step 1 find weighted average shares outstanding

Common Stock 200,000 100,000 300,000 280,000 580,000 580,000 Treasury Stock 20,000 20,000 20,000 -10,000 10,000 Common Shares Outstanding 180,000 100,000 280,000 280,000 560,000 10,000 570,000 Split Factor 2 2 1 1

Date 1/1 to 3/31 4/1/2006 4/1 to 6/29 6/30/2006 6/30 to 8/31 9/1/2006 9/1 to 12/31 Weighted average

Months
3/12 3/12 2/12 4/12

Weighted

12/12

22

Step 1 find weighted average shares outstanding shares outstanding Multiply by fraction of year and by
split factor

Date 1/1 to 3/31 4/1/2006 4/1 to 6/29 6/30/2006 6/30 to 8/31 9/1/2006 9/1 to 12/31
Weighted average

Common Stock 200,000 100,000 300,000 280,000 580,000 580,000

Treasury Stock 20,000 20,000 20,000 -10,000 10,000

Common Shares Outstanding 180,000 100,000 280,000 280,000 560,000 10,000 570,000

Months
3/12 3/12 2/12 4/12 12/12

Split Factor 2 2 1 1

Weighted 90,000 140,000 93,333 190,000 513,333

Make sure you have accounted for all 12 months and no more than 12 months!

Add em up

23

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 . . .

24

Step 3 compute basic EPS

Net income Preferred dividends Weighted average shares outstanding $3,000,000 $60,000 513,333

$__________
25

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

26

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

27

Diluted EPS
Net income Preferred dividends Weighted average shares outstanding
$3,000,000 $0 513,333 + 100,000
Diluted EPS = $__________ Both the $5.73 and the $4.89 would be reported on the face of the income statement
28

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)

29

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.
30

Treasury Stock Method

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

Any additional shares issued, over treasury stock, are added to weighted- average shares outstanding.

Purpose is to acquire treasury stock that can be reissued to option or warrant holders. If not sufficient, wed have to issue MORE shares

Exercise is assumed to occur on the first day of the year unless issue date is later. 31

Treasury Stock Method-Example: Basic Data

Assume the following: Net Income $8,000 Common Shares Outstanding (entire year)
Stock Options Outstanding Exercise Price Per Share on Options Average Price of Common Shares

6,000 2,000 $30 $40

32

Treasury Stock Method--Example

Net income Preferred dividends Weighted average shares outstanding
$8,000 Basic EPS = 6,000 Basic EPS = $1.33
33

Treasury Stock Method-Example: 3 steps

1. Options assumed exercised
(2,000*30) = $60,000 cash received 2. Shares assumed repurchased with proceeds ($60,000 / $40) = 1,500 3. Additional shares assumed issued: 2,000 from exercise less 1,500 purchased with proceeds = 500 net new shares
34

Treasury Stock Method--Example:

Net income Preferred dividends = average shares outstanding Weighted
$8,000 Diluted EPS = 6,000 + 500 Diluted EPS = $1.23
35
= $8,000/6,500 =

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

*
36

Formula for diluted EPS

dividends if + After-tax Net income preferred bond interest stock is NOT on converconvertible tible bonds Weighted average of common shares assuming maximum dilution (including options)
37

- Preferred

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.
38