Wednesday, 17 October 2007

How to calculate Earning Per Share?

If you are investor and you have read the analyst report, have you ever wonder how did the analyst compute the Earnings per share (EPS)?

EPS is one of the most commonly used corporate profitability performance measures for publicly traded firms. A company may have either a simple or complex capital structure. A simple capital structure is one that contains no potentially dilutive securities. A simple capital structure contains only common stock, nonconvertible debt, and preferred stock. On the other hand, a complex capital structure contains potentially dilutive securities such as options, warrants, or convertible securities.

All firms with complex capital structures must report both basic and diluted EPS. Firms with simple capital structures report only basic EPS.

The basic EPS calculation does not consider the effects of any dilutive securities in the computation of EPS.

  • Basic EPS = (Net Income - Preferred Dividends) / weighted average number of common shares outstanding.
The current year's preferred dividends are subtracted from net income because EPS refers to the per-share earnings available to common shareholders. Net income minus preferred dividends is the income available to common stockholders. Common stock dividends are not subtracted from net income because they are a part of the net income available to common shareholders.

Before computing the dilutive EPS, you need to understand the following terms:
  • Dilutive securities are stock options, warrants, convertible debt, or convertible preferred stock that would decrease EPS if exercised or converted to common stock.
  • Antidilutive securities are securities that would increase EPS if exercised or converted to common stock.

The numerator of the basic EPS equation contains income available to common shareholders (net income less preferred dividends). In the case of dilutive EPS , if there are dilutive securities (e.g., convertible preferred stock, convertible bonds, or warrants) that will cause the weighted average common shares to change, then the numerator must be adjusted for the following:

  • If convertible preferred stock is dilutive (meaning EPS will fall if stock is converted), the convertible preferred dividends must be added back to the previously calculated income from continuing operations less preferred dividends.
  • If convertible bonds are dilutive, then the bonds' after-tax interest expense would not be considered as an interest expense for diluted EPS. Hence, interest expense multiplied by (1-tax rate) must be added back to the numerator.

The diluted EPS equation (assuming convertible securities are dilutive) is:

  • diluted EPS = adjusted income available for common shares/weighted-average common and potential common shares outstanding

where adjusted income available for common shares is:

  • Net income - preferred dividends + Dividends on convertible preferred stock + After-tax interest on convertible debt

Remember, each potentially dilutive security must be examined separately to determine if it is actually dilutive (would reduce EPS if converted to common stock). The effect of conversion to common is only included in the calculation of diluted EPS for a given security if it is in fact dilutive.

At the end of the day, we just used these figures taken for granted. With the understanding of how the computation is done, it will give you more insight into a company capital structure. Hence for a complex capital structure company, the dilutive EPS will give a better estimation of the earning per share. Cheers.

25 comments:

patandmac said...

Computation of Basis and Diluted EPS- Need to compute basic and diluted earings per share in 2007

Net income for year $1,200,000
8% convertible bonds issued at par (1,000 per bond). Each bond is convertible into 40 shares of common stock $2,000,000
6% convertible, cumulative preferred stock, $100 par value. Each share is convertible into 3 shared of common stock $3,000,000
Common stock, $10 par value $6,000,000.00
Common stock options (granted in a prior year) to purchase 50,000 shares of common stock at $20 per share $500,000
Tax rate for 2004 40%
Average market price of common stock $25 per share

There is not changes during 2007 in the number of common shares, preferred shares or convertible bonds outstanding. There is no treasury stock.

patandmac said...

Computation of Basis and Diluted EPS- Need to compute basic and diluted earings per share in 2007

Net income for year $1,200,000
8% convertible bonds issued at par (1,000 per bond). Each bond is convertible into 40 shares of common stock $2,000,000
6% convertible, cumulative preferred stock, $100 par value. Each share is convertible into 3 shared of common stock $3,000,000
Common stock, $10 par value $6,000,000.00
Common stock options (granted in a prior year) to purchase 50,000 shares of common stock at $20 per share $500,000
Tax rate for 2004 40%
Average market price of common stock $25 per share

There is not changes during 2007 in the number of common shares, preferred shares or convertible bonds outstanding. There is no treasury stock.

Neaven said...

Hi Patandmac, I'm so sorry for my late reply. I did not realize you posted me a question until this morning when I read it again. I hope it is not too late to answer your question.

Let me try breakdown the question into a few portion so it will be easier to understand.

1.) The total outstanding number of shares for the year is $6 000 000 / $10 = 600 000

2.) There are 2000 ($2 000 000 / $1000), $1000 par, 8% convertible bonds for $2 000 000. Each convertible to 40.

3.) There are 30 000 ($3 000 000 / $100), $100 par, 6% convertible preferred stock for $3 000 000. Each convertible to 3.

4.) There are 25 000 ($500 000 / $20) stock options each allows the holder to purchase 2 (50 000 / 25 000) shares of common stock at $20 per share. (I’m not too sure if I understand this part of your question correctly.)

5.) Lastly, the average market price for common stock is $25 per share. The tax rate is 40% and the net income is $1 200 000.
Basic EPS = ($1 200 000 – 30 000 * 6% * $100) / 600 000 = $1.70

For diluted EPS, we need to verify each security separately and check if they are dilutive.

1.) For convertible bonds, we can simply check if the convertible debts are dilutive by doing the following calculation: (2000 * $1000 * 8%) * (1 – 40%) / (2000 * 40) = $1.20. Since this amount is less than $1.70, the convertible bonds are dilutive.

2.) For convertible preferred stock, dilutive EPS = ($1 200 000 - 30 000 * 6% * $100 + 30 000 * 6% * $100) / (600 000 + 30 000 * 3) = $1.74. Since this amount is bigger than $1.70, we should not take into consideration when we perform our overall dilutive EPS later.

3.) For stock option, since the exercise price < average market price, the stock option is dilutive. The net increase in common shares from the potential exercise of stock options is ($25 - $20) / $25 * 50 000 = 10 000.

4.) Now we shall combine everything together to compute the diluted EPS = ($1 200 000 – 30 000 * 6% * $100) + (2000 * $1000 * 8%) * (1 – 40%) / (600 000 + 2000 * 40 + 10 000) = $1.62

Hope I answer your question.

Anonymous said...

By the time you get this, I will have already done my exam, but for the options, do you not simply add the total amount of options to the denominator?

What if market price had not been given?

Neaven said...

Hi, I'm really sorry for my late reply the other time. Initially, I thought you were posting an illustration of the computation for the EPS. It was till later then I realised that you were asking me a question. Really sorry about that.

As for the current question, that is the part that I'm not sure if I understood your question correctly. If my assumption of your question is correct, then the way to do so for option is the way I have shown.

If the average market price is not given, is there other information that is given for you to derive it? From what I understand is you need to use the market average price. The use of market average price is to prevent market manipulation.

Lastly, all the best to your examination. :)

Anonymous said...

But does it matter whether they have been exercised or not?

Anonymous said...

Sorry, I have so many questions,
but I was reading from another site, the treasury stock method.

Therefore if option price is $20, and market is $25, you take $20 * 50,000 = 1,000,000

And then you divide 1,000,000 / $25

which potentially adds 40,000 common shares...?

I do not mean to critisize your method, but I beleive it may be a bit more logical that way?

Anonymous said...

Wait,

I think you are correct.


WHY THE HELL AM I GOING INTO ACCOUNTING


Thanks a lot
I appreciate it.

Neaven said...

Hi, take your time. Don't get too frustrated. I have a hard time learning the accounting portion the first time I took up CFA as I came from Engineering background. So, give yourself more time and learn from mistakes.

For computation of diluted EPS, you have to assume all the option are excerised using the Treasury stock method.

Anonymous said...

Exam went ok.

I did well on the EPS question but Convertible Bonds was my achilles heal.


I appreciate your help very much and your answer to the given question was very complete.

It is very hard to find good problem examples online.

Thanks again.


Cheers from Ottawa, Canada.

Neaven said...

Hi, congratulation to you. Now is my turn to take my exam which is 50 days away. I hope I can pass too. Cheers!

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