LOS G, H, and I requires us to:
describe how earnings per share are calculated and calculate and interpret a company’s earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures,
distinguish between dilutive and anti-dilutive securities and describe the implications of each for the earnings per share calculation;
and
convert income statements to common-size income statements
a. Earning per share is the most common measure of the profitability of publically traded companies.
b. EPS is usually reported on the face of the income statement.
c. A company may have two types of capital structures:
i. Simple Capital Structure. Such companies do not have capital with the potentially dilutive securities (i.e. the ones that can be converted into common stock of the company)
ii. Complex Capital Structure. Such companies usually have capital with potentially dilutive securities such as convertible debenture, convertible preference shares, warrants, employee stock options, etc.
d. All the companies with complex capital structures must report both:
i. Basic EPS, and
ii. Diluted EPS (if all the convertibles are converted)
e. Basic EPS can be calculated as:
f. Weighted Average Number of Shares can be calculated by taking the average of the number of shares held for a number of days/months during the year. For example, a company had 1,000,000 outstanding shares at the beginning of the period i.e. January. Suppose it issues 200,000 shares at the end of May and bought back 300,000 shares at the end of September. Then the weighted average number of shares would be calculated as follows:
Month |
Number of Shares Held |
Calculation of weighted average |
Weighted Average Shares |
January |
1,000,000 |
1,000,000 * 5/12 |
416,666.67 |
May |
+ 200,000 |
1,200,000 * 4/12 |
400,000.00 |
September |
– 300,000 |
900,000 * 3/12 |
225,000 |
Total |
900,000 |
1,041,666.67 |
g. Diluted EPS can be calculated as follows (for different cases):
i. Convertible Preference Share. For the calculation of diluted EPS, it is assumed that the conversion of preference share takes place at the beginning of the accounting period.
For Example: Say the net income during the year is $ 200,000 and the weighted average number of shares held is 20,000. The company has 1,000 convertible preference shares outstanding, having dividends payable of $ 10 per share and a conversion factor of 5:1.
The figures of EPS would be calculated as follows:
Basic EPS = [200,000 – (1000 × 10)] / 20,000 = $ 9.50 per share
Diluted EPS = (200,000 – 0) / (20,000 + 5,000) = $ 8.00 per share
ii. Convertible Debt. For the calculation of diluted EPS, it is assumed that the conversion of debt takes place at the beginning of the accounting period.
For Example: Say the net income during the year is $ 200,000 and the weighted average number of shares held is 20,000. The company has 100,000 debt carrying interest of 10% outstanding and convertible into 5,000 equity shares. Assume a tax rate of 40 %.
The figures of EPS would be calculated as follows:
Basic EPS = (200,000 – 0) / (20,000) = $ 10 per share
Diluted EPS = [200,000 + (100,000 × 10%) × (1 – 0.04)] / (20,000 + 5,000) = $ 8.24 per share
iii. Options / Warrants. For options or warrants, the treasury stock method is used for the calculation of diluted EPS. Under this method, it is assumed that options would be exercised, and funds would be used to buy the shares and thus the number of shares would increase by the difference amount.
For Example: Say the net income during the year is $ 200,000 and the weighted average number of shares held is 20,000. The company has 5,000 options carrying an exercise price of $ 10 and the market price of the share at beginning of the period was $ 15.
The figures of EPS would be calculated as follows:
Basic EPS = (200,000 – 0) / 20,000 = $ 10 per share
Diluted EPS (as per U.S. GAAP) = (200,000 – 0) / [20,000 + {5000 – (5,000 × 10 / 15)}] = $ 9.23 per share
IFRS follows a slightly different path for the calculation of EPS. It calculates the number of shares to be issued first and then adds the same to the existing number of shares outstanding. This gives the same answer like that in the case of U.S. GAAP, but the path is different.
NOTE: Some of the conversions are also ‘anti-dilutive’ in nature. As per both IFRS and GAAP, such securities are not included in the calculation of diluted EPS.
Also, note that changes in EPS are mainly due to:
# Changes in Net Income, which may be due to changes in operating income or due to changes in non-operating income
# Changes in the weighted average number of shares, resulting due to share buybacks, secondary offerings, or conversions.