Understanding Earnings Per Share (EPS)

1. Chapter 20 Earnings Per Share

2. Earnings Per Share (EPS) Of the myriad of facts and figures generated by accountants, the single accounting number that is reported most frequently in the media and receives by far the most attention by investors and creditors is earnings per share.

3. Net income (after tax) – Preferred dividends* Weighted average outstanding common stock Number of shares outstanding× Number of months outstanding ÷ 12 Weighted average shares outstanding Basic Earnings Per Share *Currentperiod’s cumulative preferred stock dividends (whether or not declared) and noncumulative preferred stock dividends (only if declared). Simple Capital Structure (Basic EPS)

4. A company had 200,000 shares of $50 par value common stock, 10,000 shares of 5%, $20 par value cumulative preferred stock, and 30,000 shares of 5%, $10 par value noncumulative preferred stock outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during the year. EPS would be a. $7.50 b. $7.43 c. $7.45 d. $7.38 Earnings Per Share

5. Earnings Per Share A company had 200,000 shares of $50 par value common stock, 10,000 shares of 5%, $20 par value cumulative preferred stock, and 30,000 shares of 5%, $10 par value noncumulative preferred stock outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during the year. EPS would be a. $7.50 b. $7.43 c. $7.45 d. $7.38 $1,500,000 – (10,000 × 5% × $20 par) 200,000 shares Since dividends were notdeclared, only the cumulative preferred stock dividends are subtracted.

6. Compute the weighted average number of shares of common stock outstanding. Issuance of New Shares

7. Issuance of New Shares Compute the weighted average number of shares of common stock outstanding.

8. Common shares issued as part of stock dividends and stock splits are treated retroactively as subdivisions of the shares already outstanding at the date of the split or dividend. Stock Dividends and Stock Splits

9. Compute the weighted average number of shares of common stock outstanding. Stock Dividends and Stock Splits

10. Stock Dividends and Stock Splits Compute the weighted average number of shares of common stock outstanding.

11. Retroactive treatment: Stock Dividends and Stock Splits New shares issued this period? No Yes Stock dividend or split is applied retroactively in proportion to the number of shares outstanding at the time of the dividend or split. Stock dividend or split is treated as outstanding from the beginning of the period.

12. Reacquired Shares The weighted average number of shares is reduced by the number of reacquired shares, time-weighted for the fraction of the year they were not outstanding.

13. Reacquired Shares Compute the weighted average number of shares of common stock outstanding.

14. Reacquired Shares Compute the weighted average number of shares of common stock outstanding.

15. Diluted Earnings Per share Complex Capital Structure (dual EPS) • Potentially dilutive securities: • Stock options, rights, and warrants • Convertible bonds and stock • Contingent common stock issues Equity contracts Convertible securities Contingently issuable shares Treasury stock method If-converted method Dilution/Antidilution Test

16. Dual presentation of Earnings Per Share: Basic EPS Diluted EPS Complex Capital Structure

17. Options, Rights, and Warrants The treasury stock method assumes that proceeds from the exercise of equity contracts are used to purchase treasury shares. This method usually results in a net increase in shares included in the denominator of the calculation of diluted earnings per share. Proceeds At average market price Used to Purchase treasury shares

18. Proceeds from assumed exercise • Average market price of stock Options, Rights, and Warrants • Determine new shares from assumed exercise of equity contract. • Compute shares purchased for the treasury.

19. Determine new shares from assumed exercise of equity contract. Compute shares purchased for the treasury. Compute the incremental shares assumed outstanding. Options, Rights, and Warrants • New shares from assumed exercise (1) • Less: Treasury shares assumed purchased (2) • Net increase in shares outstanding (3)

20. Options, Rights, and Warrants When the exercise price exceeds the market price, the options are antidilutive.

21. Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. The net increase in the dilutive earnings per share denominator is a. 25,000 shares b. 5,000 shares c. 3,125 shares d. 1,875 shares Treasury Stock Method

22. Treasury Stock Method Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. The net increase in the dilutive earnings per share denominator is a. 25,000 shares b. 5,000 shares c. 3,125 shares d. 1,875 shares New shares = 5,000 Treasury shares = 3,125 (5,000 × $50) ÷ $80 Incremental shares = 1,875 (5,000 - 3,125)

23. Next: Convertible Securities

24. The if-converted methodis used for Convertible debt and equity securities The method assumes conversion occurs as of the beginning of the period or date of issuance, if later. Convertible Securities

25. The assumed conversion of convertible bonds or preferred stock has two effects on dilutive earnings per share: Increases the denominator by the number of common shares issuable upon conversion. Increases the numerator by decreasing after-tax interest expense on convertible bonds, and dividends on convertible preferred stock. Convertible Securities

26. Dilutive earnings per share may decrease or increase after the assumed conversion. Convertible Securities If dilutive earnings per share decreases, the securities are dilutive and are assumed converted. If dilutive earnings per share increases, the securities are antidilutive and are not considered converted.

27. Assume net income (after tax) of $500,000, cumulative convertible preferred stock dividends of $25,000, common stock outstanding of 50,000 shares, and a tax rate of 30%. The convertible preferred stock is convertible into 5,000 shares of common stock. Is the convertible preferred stock dilutive? If-Converted Method

28. EPS without conversion: • $500,000 – $25,000 • 50,000 shares • = $9.50 EPS • EPS afterassumedconversion: • $500,000 – $0 • 55,000 shares Dilutive. • = $9.09 EPS If-Converted Method If the preferred stock is converted, we would not have dividends and the number of shares of common stock would increase by 5,000 shares. There is not a tax effect.

29. Assume net income (after tax) of $500,000, convertible bonds with interest expense of $50,000, common stock outstanding of 50,000 shares, and a tax rate of 30%. The bonds are convertible into 2,000 shares of common stock. Are the convertible bonds dilutive? If-Converted Method

30. EPS without conversion: • $500,000 • 50,000 shares • = $10.00 EPS • EPS after assumed conversion: • $535,000 • 52,000 shares No, they are antidilutive. • = $10.29 EPS If-Converted Method If the bonds are converted, net income would increase by $35,000 (after taxes) and the number of shares of common stock would increase by 2,000 shares.

31. Order of Entry for Multiple Convertible Securities When a company has more than one potentially dilutive security, they are considered for inclusion in dilutive EPS in sequence from the most dilutive to the least dilutive.

32. Contingently Issuable Shares Contingent shares are issuable in the future for little or no cash consideration upon the satisfaction of certain conditions. Future

33. Contingently Issuable Shares Contingent shares are included in dilutive EPS if: Shares are issued merely due to passage of time. Some target performance level has already been met and is expected to continue to the end of the contingency period. Example: Additional shares may be issued based on future earnings.

34. Contingently Issuable Shares Contingent shares are considered outstanding common shares and are included in basic EPS as of the date that all necessary conditions have been satisfied.

35. Summary

36. Summary

37. Financial Statement Presentation of EPS Data • Income from continuing operations. • Discontinued operations. • Extraordinary items. • Cumulative effect of change in accounting principle. • Net income. Earnings per share values are desirable (but not required) for extraordinary items and discontinued operations.

38. End of Chapter 20