Earnings Per Share (EPS) Wali Memon1 Wali Memon
Key Issues 1. Basic EPS 2. Weighted average common shares 3. Pecking order 4. Treasury stock transactions 5. Dilution 6. Diluted EPS 7. options and warrants: treasury stock method 8. Convertible bonds and preferred stock: if converted method 9. Determining dilution vs anti-dilution2 Wali Memon
Basic EPS Net income - Preferred dividendsBasic EPS = Weighted average number of common stock outstandin g weight shares outstanding by fraction of year; changes due to share repos, issuances, option exercises, etc.. 3 Wali Memon
Basic EPS - ExampleOn January 1, 2001 Solomon Corporation had: 160,000 common shares outstanding. 10,000 preferred shares, $100 par value, 7%On September 1, 2001 the company issued 40,000additional common shares.The net income for 2001: $1,257,331 x0.07 = $70,000Preferred dividends = 10,000 x 100 (a) Shares (b) Portion Weighted sharesWhat is the basic EPS? Time span outstanding of year (col. a x col. b) Jan 1 - Aug 31 160,000 2/3 106,667 Sep1 - Dec 31 200,000 1/3 66,667 173,3334 Wali Memon $1,257,331- $70,000 Basic EPS = = $6.85 per share 173,334 shares
Basic EPS (cont’d) EPS is from common shareholders’ viewpoint Pecking order of suppliers of capital: 1. Debt holders 2. Preferred stock holders 3. Common stock holders ? Why are preferred dividends subtracted, but not bond interest? Ex. E15-14; P15-45 Wali Memon
Effect of Treasury Stock Transactions 1. Purchase of treasury shares: DR Treasury stock (contra O/E A/C) CR Cash 2. resale of treasury shares: DR Cash DR APC CR Treasury stock (at cost, from 1.)or CR APC DR (or CR) to APC is economic loss (or gain) that is not recognized in accounting 6 Wali Memon
Effect of Treasury Stock Transactions (cont’d)Key point: Transactions in own common stock don’t affect NI (proprietary viewpoint), only affect number of shares outstanding; so firms can manipulate EPSQ:How does transaction timing during the year affect EPS?Ex. E15-16; P15-87 Wali Memon
Diluted EPS SFAS No. 128 requires companies with complex capital structures to compute another measure called diluted earnings per share. Income adjustments due to Net income - Preferred dividends + dilutive financial instrumentsDiluted EPS = Weighted average number of + Newly issuable shares due to common shares outstanding dilutive financial instruments (1) Options; and (2) Convertible securities can: Only dilutive securities Decrease EPS dilutive are included in the diluted 8 Wali Memon EPS calculation Increase EPS anti-dilutive
Conversion Ratio Income adjustments due to dilutive financial instruments Conversion ratio = Newly issuable shares due to dilutive financial instruments The dilutive effect of financial instruments (for example, options warrants, and convertible bonds) on EPS is calculated starting with the instrument with the lowest conversion rate (i.e. most dilutive), and working9 up to the instrument with the highest conversion rate Wali Memon (i.e. least dilutive).
Step 1: calculate the effect of options and warrants on EPS Treasury Method: Q: Option exercise price < Market price Yes NoOptions have dilutive effect include Options do notthem in diluted EPS: have dilutive1. Assume all options are exercised effect notadd new shares. included in diluted EPS.2. Assume proceeds (# shares xexercise price) are used to repurchasepreviously issued common sharessubtract these shares. 10 Wali Memon
Example: Now assume that Solomon Corporation issued options to buy 20,000 shares of common stock at $100 per share. The market price is $114. What is the diluted EPS? Option exercise price 100$ < Market price 114$ Upon full exercise of option additional 20,000 shares The proceeds 20,000 X $100 = $2,000,000 are assumed to be used to repurchase previously issued common shares at the $114 market price. $ 2 ,000 ,000 = 17 ,544 shares $ 114 per share The dilution effect: 20,000 – 17,544 = 2,456 shares11 $1,257,331 - 70,000 Diluted EPS = Wali Memon = $6 .75 per share 173,334 + 2,456
Step 2: calculate effect of convertible securities on EPS ‘if-converted method’ (one convertible security) Increase in EPS denominator: calculate additional shares under full conversion. increase in (after tax ) net incomeConversion Increase in EPS numerator: Calculate increase in net income if step 1 ratio= < Diluted EPS After # shares converted interest had not been paid on the convertible bonds/preferred shares. Yes No Dilutive effect: Add increase No dilutive effect: leave in numerator and Denominator to Dilutive EPS after step 1 as-is. 12 DilutiveWali Memon EPS.
Example cont’: Solomon Corporation also has: $1,000,000 of 5% convertible bonds, with par (face) value of $1,000 per bond Each $1,000 bond pays interest of $50 per year and is convertible into 10 shares of common stock. 35% tax rate What is the dilutive EPS now? Increase in denominator: 1,000 x 10 = 10,000 shares Increase in numerator: 1000 x $50 x (1-0.35)=$32,500 32 ,500 = 3 .25 < 6 .75 10 ,000 $1,257,331 - 70,000 + 32,500Diluted EPS = = $6.57 per share13 Wali Memon 173,334 + 2,456 + 10,000
Summary of example Basic EPS = $6.85 (slide #4) 1. After considering effect of options = $6.75 (slide #11) 2. After considering effect of convertible bonds = $6.57 (slide #13)Q: Why does dilution effect of options always come before convertibles?14 Wali Memon
If converted method with multiple convertible securities Rank all convertible securities by conversion ratio; take convertible with lowest conversion ratio* For the chosen convertible security check: increase in (after tax ) net income < Diluted EPS After step 1 # shares converted Yes: Dilutive No: Anti-dilutive Calculate New EPS Stop Take the convertible with the next lowest conversion ratio 15 Wali Memon* Options have lower conversion ratio, therefore come before convertibles.