Over the last few posts we discussed the basics of the income statement, treatment of non recurring items and accounting policy changes on the income statement, revenue recognition on the income statement and expense recognition. Today we move on the next topic ,i.e. EPS or earnings per share wherein we shall cover the various ways in which we can calculate earnings per share under different capital structures. So let’s begin….
Earnings per share (EPS)
‘Earnings per share’ or EPS measure is an important measure for shareholders as it allows each shareholder to know his share in the company’s earnings. ‘Earnings per share’ is required to be reported on the income statement for net income as well as income from continuing operations. EPS is calculated for common stock shares only. It is calculated differently for a company with a simple capital structure and for a company with a complex capital structure.
Simple capital structure vs. Complex capital structure
A company that does not have dilutive securities is said to have a simple capital structure and those that have dilutive securities are said to have a complex capital structure. Dilutive securities are securities that can be converted into common stock shares. For example, convertible bonds, convertible preferred stock, employee stock options and warrants. They are called dilutive as on conversion into common stock they dilute the earnings per share by increasing the quantity of common stock shares.
Companies with a simple capital structure are required to report the basic EPS. The basic earnings per share formula is given as;
Net Income – preferred dividends
Weighted average number of common stock outstanding
EPS is calculated for Net Income – preferred dividends because that is the net income that is available to the common stock holders after paying off preferred stock holders. Preferred stock holders receive a fixed amount of dividend each year which is paid out before any dividends are distributed to the common stock holders. Common stock holders are always the last to be paid, after the creditors and preferred stock holders have been paid.
Weighted average number of common shares is the number of common shares outstanding during the year weighted by the portion of year for which they were outstanding.
Companies that have a complex capital structure are required to report a diluted EPS, i.e. what would be the earnings per share assuming all the dilutive securities were converted to common stock. Anti dilutive securities are not considered in the calculation of Diluted EPS. Anti dilutive securities are those the conversion of which increases the earnings per share.
Diluted EPS is lower than the basic EPS. We will see the computation of diluted EPS for each type of dilutive security.
Diluted EPS for a company having convertible preferred stock
In case of a company having convertible preferred stock, Diluted EPS is calculated assuming the convertible preferred stock is converted into common stock. In this case, the quantity of common stock would have increased and the company would not have paid out any preferred dividends. Therefore Diluted earnings per share formula would be given as;
Weighted average common stock + shares from conversion of conv. Pref. stock
Diluted EPS for a company having convertible debt
Just like in the case of preferred stock, in case of a company having convertible debt outstanding, Diluted EPS is calculated assuming the convertible debt is converted into common stock. In that case, the debt would cease to exist and common stock outstanding would increase. Again the company would not pay out interest on the debt. Therefore, interest expense after tax needs to be added back to the net income to calculate diluted EPS. The diluted earnings per share formula in this case is given as,
Net Income – preferred dividends +after tax interest expense
Weighted average common stock + shares from conversion of conv. debt
Diluted EPS for a company having stock options and warrants
In case of a company having stock options and warrants, diluted EPS is calculated using the treasury stock method. Under this method it is assumed that the stock options are dilutive. Stock options are dilutive only when their exercise price is below the market price. The common stock outstanding is adjusted for new shares issued on exercise of stock options minus the shares repurchased by the company with the cash received on exercise of the options. No adjustment is made to the numerator.
The diluted earnings per share formula in this case is given as;
Net Income – preferred dividends
Wt. avg. common stock +new shares issued – shares repurchased
Therefore, diluted EPS takes into account the maximum potential dilution of the earnings per share. This brings us to the end of the post on earnings per share..hope you liked reading it and will make sure to share it…embedded below is a short ppt covering the post….to download it follow the link below it…
…in the next post we will cover common size income statements and the various ratios presented on it….tune in again in a few days…or alternatively subscribe and receive updates by email 🙂
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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