Earnings Per Share (EPS)

RCJ Chapter 15

(836-842)

Key Issues
1.
2.
3.
4.
5.
6.
7.
8.

9.

Basic EPS
Weighted average common shares
Pecking order
Treasury stock transactions
Dilution
Diluted EPS
options and warrants: treasury stock method
Convertible bonds and preferred stock: if
converted method
Determining dilution vs anti-dilution
Paul Zarowin

Basic EPS
Basic EPS

Net income - Preferred dividends

Weighted average number of common stock outstanding

weight shares outstanding by fraction of year;

changes due to share repos, issuances, option
exercises, etc..

Paul Zarowin

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
(a) Shares (b) Portion Weighted shares
Time span
outstanding of year
Jan 1 - Aug 31
160,000
2/3
Sep1 - Dec 31
200,000
1/3

Basic EPS

(col. a x col. b)
106,667
66,667
173,333

$1,257,331 - $70,000
$6.85 per share
173,334 shares

Basic EPS (contd)

EPS is from common shareholders viewpoint
Pecking order of suppliers of capital:
1.
Debt holders
2.
Preferred stock holders
3.
Common stock holders

Why are preferred dividends subtracted, but

not bond interest?

Ex. E15-14; P15-4

Paul Zarowin

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:

or

DR Cash
DR APC
CR
CR

Treasury stock (at cost, from 1.)

APC

DR (or CR) to APC is economic loss (or gain) that is not

recognized in accounting

Paul Zarowin

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
Q:How does transaction timing during the year
affect EPS?
Ex. E15-16; P15-8

Paul Zarowin

Diluted EPS

SFAS No. 128 requires companies with complex

capital structures to compute another measure
called diluted earnings per share.

Diluted EPS
=

Income adjustments due

Net income- Preferred dividends to dilutive financial
+
instruments
Weighted average number + Newly issuable shares
due to dilutive financial
of common shares
instruments
outstanding

(1) Options; and (2) Convertible securities can:

Only dilutive securities
Decrease EPS dilutive
are included in the
Increase EPS anti-dilutive
diluted EPS calculation
Paul Zarowin
8

Conversion Ratio
Income adjustments due
to dilutive financial
Conversion ratio =
instruments
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).
Paul Zarowin

Step 1: calculate the effect of

options and warrants on EPS

Treasury Method:
Q: Option exercise price < 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.

Paul Zarowin

10

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$ < 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
$2,000,000
17,544 shares
market price.
$114 per share
$1,257,331 - 70,000
$6.75 per share
effect:
20,000

17,544 = 2,456
173,334 2,456

Diluted EPS

The dilution
shares

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.
increase in (after tax) net income
Diluted EPS After step 1
Conversion
# shares converted
ratio=

Yes

No

Dilutive effect: Add

No dilutive effect:

increase in numerator and

Denominator to Dilutive EPS.

leave Dilutive EPS after

step 1 as-is.

Paul Zarowin

12

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

32,500
3.25 6.75
10,000

$1,257,331 - 70,000 32,500

Diluted EPS
$6.57 per share
173,334 2,456 10,000

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?

Paul Zarowin

14

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:

increase in (after tax) net income

Diluted EPS After step 1
# shares converted
Yes:
Dilutive

Calculate New EPS

No: Antidilutive

Stop

Take the convertible with

the next lowest
conversion ratio

* Options have lower conversion ratio, therefore come before

convertibles.
Paul Zarowin

15

Exercises

E15-14

P15-4

P15-12

Paul Zarowin

16