Earnings per Share

The Introductory Lecture

for 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.

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 3
There may be two EPS
numbers for each item:
Basic Diluted
Reflects the
Considers only maximum potential
common shares dilution from all
outstanding possible stock
conversions that
would have
decreased EPS.
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 Relation between
Basic and Diluted EPS

5
Diluted earnings per share
I like to think of it as the

‘worst case scenario’

It is the lowest possible number we’d
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
Common nonconvertible
Stock preferred stock.
It has no convertible
securities, stock
options, warrants, or
other rights
outstanding.
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 Capital Structures
Complex
Complex Capital
Capital Structure:
Structure:
The
The corporation
corporation has
has one
one or
or
more
more instruments
instruments
outstanding
outstanding that
that could
could result
result
in
in issuance
issuance of
of additional
additional
Convertible common
common shares.
shares.
Preferred

Convertible
Bonds
Stock
Options

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Capital Structures
Therefore,
Therefore, aa company
company
with
with potential
potential per
per share
share
dilution
dilution isis considered
considered to
to
have
have aa complex
complex capital
capital
structure.
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 13
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

Common
Common Treasury Split
Date Shares Months Weighted
Stock Stock Factor
Outstanding
1/1 to 3/31 200,000 20,000 180,000 3/12
4/1/2006 100,000 100,000
4/1 to 6/29
6/30/2006
6/30 to 8/31
9/1/2006
9/1 to 12/31
Weighted average

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 Step 1 – find weighted average
shares outstanding

Common
Common Treasury Split
Date Shares Months Weighted
Stock Stock Factor
Outstanding
1/1 to 3/31 200,000 20,000 180,000 3/12
4/1/2006 100,000 100,000
4/1 to 6/29 300,000 20,000 280,000 3/12
6/30/2006
6/30 to 8/31
9/1/2006
9/1 to 12/31
Weighted average

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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
All stock
stock splits
splits and
and stock
stock
dividends
dividends must
must be be
incorporated
incorporated into
into the
the
computation
computation of of
weighted
weighted average
average
shares
shares outstanding.
outstanding.
This
This must
must done
done for
for all
all
periods
periods presented
presented inin
the
the financial
financial
statements.
statements.
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 Step 1 – find weighted average
shares outstanding

Common
Common Treasury Split
Date Shares Months Weighted
Stock Stock Factor
Outstanding
1/1 to 3/31 200,000 20,000 180,000 3/12 2
4/1/2006 100,000 100,000
4/1 to 6/29 300,000 20,000 280,000 3/12 2
6/30/2006 280,000 280,000
6/30 to 8/31 580,000 20,000 560,000 2/12 1
9/1/2006
9/1 to 12/31
Weighted average

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Stock Splits & Dividends
This year’s 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

Common
Common Treasury Split
Date Shares Months Weighted
Stock Stock Factor
Outstanding
1/1 to 3/31 200,000 20,000 180,000 3/12 2
4/1/2006 100,000 100,000
4/1 to 6/29 300,000 20,000 280,000 3/12 2
6/30/2006 280,000 280,000
6/30 to 8/31 580,000 20,000 560,000 2/12 1
9/1/2006 -10,000 10,000
9/1 to 12/31 580,000 10,000 570,000 4/12 1
Weighted
average 12/12

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

Common
Common Treasury Split
Date Shares Months Weighted
Stock Stock Factor
Outstanding
1/1 to 3/31 200,000 20,000 180,000 3/12 2 90,000
4/1/2006 100,000 100,000
4/1 to 6/29 300,000 20,000 280,000 3/12 2 140,000
6/30/2006 280,000 280,000
6/30 to 8/31 580,000 20,000 560,000 2/12 1 93,333
9/1/2006 -10,000 10,000
9/1 to 12/31 580,000 10,000 570,000 4/12 1 190,000
Weighted average 12/12 513,333
Make sure you have Add
accounted for all 12 months
‘em up
and no more than 12 months! 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 let’s plug everything into the formula . . .

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Step 3 – compute basic EPS
Net income – Preferred dividends
Weighted average shares outstanding

$3,000,000 – $60,000
513,333
 $__________

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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 we’d 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
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

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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, we’d 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

Net income – Preferred dividends

Weighted average shares outstanding

Basic EPS = $8,000

6,000

Basic EPS = $1.33

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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

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Treasury Stock Method--Example:

Net income – Preferred dividends

Weighted
= average shares outstanding

$8,000
Diluted EPS = = $8,000/6,500 =
6,000 + 500

Diluted EPS = $1.23

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 Short-cut formula:
Avg Mkt Price – Option
Number of shares Price
Net new shares to which
= option holders *
are entitled Avg Mkt Price

2,000 *

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Formula for diluted EPS

- Preferred
dividends if + After-tax
Net income preferred bond interest
stock is NOT on conver-
convertible tible bonds
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.

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