Traditionally, the main objective of management is to maximize a firm's net income, or maximize earnings per share. Earnings per share (EPS) represent the net income earned for each share of outstanding common stock. Arriving at EPS, at first glance, appears to be a simple calculation of the basic formula: net income divided by the number of shares of common stock outstanding. However, as you will see, calculations of EPS involve many factors to come up with the numbers to be used in the numerator and denominator of the formula.
Generally there is a high relationship between EPS, cash flow and stock price; and they normally rise if firm sales also rise. But stock prices depend not just on today's earnings and cash flow, but also on future cash flow and riskiness of the future earnings which also have an effect on stock prices. There are several financial formulas used in conjunction with the EPS calculation to help determine the soundness of a firm. Maximizing EPS is no easy task; some company actions may well increase earnings but may inadvertently reduce stock price, while other actions may boost stock prices but reduce earnings. For example:
A company undertakes large expenses today that are designed to improve future performance. These expenditures will likely reduce EPS yet the stock market may respond positively if it foresees that these expenditures will significantly add to future earnings.
By contrast, a company that may undertake actions today to increase its earnings may see a drop in its stock price if market believes that these actions negatively impact future earnings and/or dramatically increase the firm's risk.
As mentioned, management's primary goal should be to maximize stockholders wealth - this is maximizing stock price. They take actions with intend to raise funds to maximize the value of the firm. Therefore management must effectively communicate the reason for any decline in earnings; if not, the company stock price will probably decline after the lower EPS are reported.
Understand that the price of the firm's stock also depends on the cash flow paid to shareholders, the timing of cash flows and their riskiness. The risk level of cash flow is affected by the financial environment as well as by investment, financing and dividend policy decisions made by financial managers.
The following actions exist or are implanted to motivate managers to act in the best interests of stockholders:
1. Managerial compensation
2. Direct intervention by stockholders
3. Threat of firing
4. Threat of takeover
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Firms with publicly held common stock or potential common stock are required to report EPS information in the Financial Statements. Potential common stock includes securities such as stock options, warrants, convertibles, and contingent stock agreements.
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SIMPLE CAPITAL STRUCTURE
A corporation's capital structure is considered SIMPLE if it consists only of common stock or include no potentially dilutive convertible securities, options, warrants, or other rights that upon conversion or exercised could in total dilute EPS of common shares (the term DILUTIVE is to be explained later in this article). The formula for calculating EPS is:
Net income preferred dividends
___________________________
Weighted Average Number of Shares Outstanding
If the preferred stock is cumulative and dividend is not declared during the period, it constitutes the basis for the per share amounts reported. Shares issued or purchased during the period affect the number of outstanding shares and must be weighted by the fraction of the period they are outstanding. When stock dividends or stock splits occur, calculation of the weighted average number of share require restatement of the shares outstanding before the stock dividends or split (they are assumed to have been outstanding since the beginning of the year).
If a stock dividend or stock split occurred AFTER the end of the year, but BEFORE the Financial Statement are issued, the weighted average number of shares outstanding for the year and any other years presented in comparative form must be restated.
COMPLEX CAPITAL STRUCTURE
A firm is considered to have a COMPLEX capital structure if it includes securities that could have a dilutive effect on earnings per common share. A COMPLEX capital structure requires a dual presentation of EPS each with equal prominence of the face of the Income Statement. The dual presentation consists of basic EPS and Diluted EPS. However, if the securities in the capital structure are antidilutive, that is, they increase EPS, companies with COMPLEX structure do not report this.
Remember that EPS is computed only for common stock, not for preferred stock.
For instance a corporation that earned $10 million last year and has 10 million common shares outstanding would report earnings of $1 per share. The figure is calculated after paying taxes and after paying preferred shareholders and bondholders. The company must report earnings per share in two levels: BASIC EARNINGS PER SHARE which doesn't count stock options, warrants, and convertible securities and fully DILUTIVE EARNINGS PER SHARE which includes those securities.
Computation of EPS is usually straight forward: net income minus preferred stock dividends (Net income available to common stockholders) is divided by the number of weighted average of common shares outstanding. For instance a corporate reports net income of $350,000 and declares and pays preferred dividends of $50,000 for the year. The weighted average number of common stock outstanding during the year is 100,000 shares. EPS is $ $3.00, as computed:
Net income preferred dividends
___________________________
Number of Weighted Average of common shares outstanding
= Earnings Per Share
Using the figures above:
$350,000 $50,000
_______________ = $3.00
100,000
This EPS is earned by each share of common stock, or allocated to each share of common stock, and IS NOT the dollar amount paid to stockholders in the form of dividends. As mentioned, EPS is required to be disclosed on the face of the Income Statement of a company's reports. Companies with additional components: discontinued operations, extraordinary item, or cumulative effect of a change in accounting principle must report per share amount for these line items either on the face of the Income Statement or in the notes of the Financial Statements.
HERE ARE THE STEPS FOR CALCULATING EPS (material from Intermediate Accounting Text)
STEP ONE: Compute the weighted average number of common stock shares outstanding.
A. When common shares are issued for assets during the period, weight them according to the length of time in the period the stock is outstanding in relation to the total time in the period.
B. When common shares are issued in connection with a stock split or stock dividend declared during the period, give retroactive treatment to these shares. Give retroactive treatment even if the stock dividend or split is declared after the end of the period but before the financial statements are published. Restate EPS in Financial Statements for prior periods presented.
Here is how:
FIRST: Begin with the number of common shares outstanding at the beginning of the period. Assume they were outstanding the entire year; multiply the number by 12/12 to get an equivalent amount. Enter the equivalent amount in the weighted average column.
SECOND: Take the first transaction that occurred during the year that changed the number of shares outstanding and properly adjust the balance in the Weight average column.
- If shares were issued for assets, weight the new shares by multiplying thy by a fraction. The numerator of the fraction is the number of moths in the period the shares were outstanding; the denominator is the number of months in the year. Add this equivalent amount in the weighted average column; arrive at a new balance.
- If shares were issued in a stock dividend or a stock split, retroactively adjust for these shares by taking an appropriate multiple of the existing balance in the Weighted Average column. Ignore the date of the stock dividend or split; the multiple is determined by the size of the stock dividend or split. Arrive at a new balance.
- If shares were acquired as treasury stock or retired by the corporation, weight the shares for the time they were not outstanding and deduct this equivalent amount from the existing balance. Arrive at a new balance.
THIRD: Take each of the other transactions that occurred during the year that changed the number of common shares outstanding and properly adjust the balance in the Weighted Average column as shown on item labeled SECOND above. Handle each transaction in order of date. Example:
Data: January 1, 2007 100,000 shares were outstanding
April 1, 2007 Issued 40, 000 shares for cash
June 1, 2007 Declared a 40% stock dividend
October 1, 2007 Declared a 2-for-1 split
December 1, 2007 Issued 60,000 shares for cash
Calculation of data above:
Date Actual Shares Calculation Weighted Average
1/1/07 100,000 100,000 x 12/12= 100,000
4/1/07 40,000 40,000 x 9/12 = 30,000
_______ ______
140,000 New Balance 130,000
6/1/07 56,000 40% stock dividend x140%
______ _______
196,000 New Balance 182,000
10/1/07 196,000 2 for 1 split x2
_________ _________
392,000 New Balance 364,000
12/1/07 60000 60 x 1/12 5,000
_______ _________
452,000 NEW BALANCE 369,000
Now assume that a 10% stock dividend was declared on January 7, 2008, before the financial statements for 2007 were issued. The weighted average number of common stock shares outstanding would be 405,900 (369,000 x 110% = 405,900) and the actual number of common shares outstanding to be reported on the Balance Sheet at December 31, 2007 would still be 452,000.
STEP 2: Compute basic EPS before any assumptions or adjustments:
Basic formula: Net income Preferred dividends (actually declared)
__________________________________________
Weighted Average Number of Common Shares Outstanding
The numerator should be the income available to common stockholders which is net income minus preferred stock dividend requirements. Thus in the numerator, deduct the preferred dividends actually declared. If the preferred stock is cumulative, deduct the preferred dividends current year preference as to dividends even if no dividends were declared. Dividends in arrears for prior years have no effect on the current year's basic EPS calculations. Note that dividends declared and/or paid during the year on common stock have no effect on this computation. Also if there is a net loss rather than a net income, the amount of the loss is increased by the preferred dividends.
STEP 3: Compute Diluted Earnings per share.
A. The basic formula is adjusted as follows:
Net Income Preferred dividends +/ adjustments
_________________________________________ __
Weighed Average Number of Common shares Outstanding +
Weighted Average Number of Potential Common shares
B. Treatment of convertibles: Use the IF CONVERTED method
For a better understanding: Convertible securities are corporate securities usually preferred shares or bonds that are exchangeable for a set number of another form (usually common shares) at a restated price. Convertibles are appropriate for investors who want higher income that is available from common stock, together with appreciation potential than regular bond offers. The convertible feature is usually designed as a sweetness measure to boost the marketability of the stock or preferred stock.
FIRST: Assume the convertible is converted to common stock, if the effect of that assumption is dilutive.
A quick test to determine if a CONVERTIBLE DEBT instrument is antidilutive is as follows: if the amount of interest net of taxes per common share obtainable upon conversion exceeds basic EPS, the effect is antidilutive that is, it increases earnings per share amounts.
A quick test to determine if a CONVERTIBLE PREFERRED STOCK is antidilutive as follows: if the amount of preferred dividends per common share obtainable on conversion exceeds basic EPS, the effect is antidilutive.
SECOND: For a CONVERTIBLE PREFERRED STOCK add back the preferred dividends, (that had been deducted in the basic formula) in the numerator and add an appropriate weighted average number of potential common shares (assumed to be outstanding) in the denominator of the diluted EPS formula.
THIRD: For CONVERTIBLE DEBT, add back interest and deduct tax savings due to interest in the numerator and add an appropriate weight average number of potential common shares in the denominator. Note that there is no related tax effect on preferred dividends because preferred dividends are not a tax deductible item.
FOURTH: Assume the conversion takes place at the beginning of the period for which EPS is being calculated or at the date of the issuance of the convertible, whichever is later (more recent).
FIFTH: If there is a scale of conversion rates, use the rate that is the most advantageous from the standpoint of the security holder.
C. Treatment of options and warrants:
DILUTED EPS Stock Options and Warrants
Stock options and warrants outstanding are included in diluted EPS unless they are antidilutive. If the exercise price of the option or warrant is LOWER than market price of the stock, common shares are reduced. In this case, the options or warrants are anti-dilutive because their assumed exercise leads to an increase in EPS.
FIRST: Assume the options and warrants are exercised if the effect of that assumption is dilutive. An option or warrant is dilutive if the average market price of the common stock during the period is GREATER than the exercise price of the option or warrant.
SECOND: Use the TREASURY STOCK METHOD. Assume that the proceeds (from the exercise of the options or warrants) are used to purchase treasury stock at the average market price for the period. Thus, shares will be added to the EPS denominator because of the assumed exercise, and then a smaller number of shares will be deducted from the denominator because of the assumed purchase of treasury stock. Weight the resulting net number of common equivalent shares according to the time they are assumed to be outstanding.
THIRD: Assume the exercise occurs at the beginning of the period or at the date of issuance of the options or warrants, whichever is the later.
D. Treatment of contingent issuance agreements:
FIRST: Common stock contingently issuable with the only condition being the mere passage of time should be assumed to be outstanding for computing diluted EPS.
SECOND: common stock contingently issuable upon condition of the attainment or maintenance of a level of earnings should be considered outstanding in computing diluted EPS if that level is currently being attained.
THIRD: Common stock contingently issuable upon condition of the attainment of a market price level should be considered an outstanding share if that level is met at the end of the current year
(End of material from Intermediate Accounting Text).
CONCLUSION
As you can see, when attempting to follow these steps numerous questions arise. The person doing the calculations must know the terminology well, as well as, fully understand the steps and exceptions to some of the steps and rules mentioned. The financial manager must also have accurate amounts of the financial instruments and incomes involved. Any missteps and manipulations, whether deliberate or unintentional, will deliver inaccurate information to the stockholders and other stakeholders. Today erroneous calculations are bringing down many corporations; the inexperienced or greedy managers (especially financial managers) are usually manipulating the data and even omitting important information on the Financial Statements.
Though calculation of EPS may not be considered complicated by many, it is still very intensive and involves more in-depth information and other financial management formulas to determine a more accurate profitability forecast of a firm, or EPS. EPS formula should not be the only criteria used to determine the earnings and value of common stock.
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My class notes from Advanced Intermediate Accounting (Chapter 17)
Kieso, D. E., Weygandt, J. J., and Warfield, T. D. (2001). INTERMEDIATE ACCOUNTING. New York. John Wiley & Sons, Inc.