Earnings per share (EPS)
Earnings Per Share (EPS) Definition
Earnings per share (EPS) is the net income divided by the average number of common shares outstanding during the year; also called net income per share. When a company allocates a portion of its profit to each common stock share it is called earnings per share (EPS).
Earnings per share (EPS) is one of the most popular, if not the most popular, financial statistic reported in financial publications. The relationship between EPS and the stock’s market price is called the price earnings ratio (PE ratio) and is presented for most stocks listed on the stock page of newspapers. Thus, an understanding of how EPS is calculated and its uses and limitations is necessary in order to be an informed user of financial information.
Why EPS is important to calculate?
As a way of summarizing performance for a particular time period, GAAP requires companies to report information regarding earnings per share (EPS). Because this information is a highly condensed description of a large number of transactions and other events, it tends to be imperfect in communicating information to users.
Nonetheless, EPS is used extensively by participants in the capital markets, primarily in comparisons of one company’s current results with those that it achieved in the past and with those achieved by other firms. The ratio of the market value of the stock to EPS (known as the price-earnings ratio, or earnings multiple) is used widely and often reported in daily listings of stock activity and prices. Additionally, the amount of dividends paid per share is often compared with EPS.
Calculating Earnings Per Share (EPS) – The Basics
The rules regarding the calculation of EPS are complex. Our purpose here is to present an overview of the calculation. In the simplest sense, EPS is calculated by dividing net income available to common shareholders by the weighted average number of outstanding common shares.
EPS is meaningful only in regard to common stockholders. This is because preferred shareholders have claims to only the stipulated dividend.
Net Income Available to Common Shareholders
Net income available to common shareholders is equal to net income less preferred stock dividends declared. If there is no preferred stock, the numerator of the formula will be simply net income. To illustrate, assume that the Mori Corporation earned net income of $1,562,500 (or the year ended December 31, 2019. The firm
declared the following dividends during 2019.
Common Dividends = $125,000
Preferred Dividends = 62,500
In this case, net income available to common shareholders is $1,500,000, or $1,562,500 – $62,500. The common dividends declared are ignored because all the earnings after preferred dividends are theoretically available to common shareholders whether or not returned in the form of dividends.
Weighted Average Number of Common Shares Outstanding
If a corporation has not issued any additional common stock, the denominator of the earnings per share (EPS) formula will be simply the number of common shares outstanding at the end of the year. In many cases, however, firms issue additional shares of common stock at various times during the year. In these cases, it is incorrect to take the total number of shares outstanding at the end of the year, because the firm did not have benefit of the cash or other assets generated from the additional stock issue for the entire year. Therefore a weighted average number of shares must be calculated based on the number of months that the shares were outstanding.
To demonstrate, assume that the Mori Corporation has 1 million shares of common stock outstanding on January 1, 2019. During the year, the firm issued the following additional common stock:
The weighted average number of common shares outstanding is 1,225,000, calculated as follows:
In effect, the number of shares outstanding for any part of the year is multiplied by the fraction of the year in which they were outstanding. In a full year, 12/12ths must be accounted for.
Based on this data, earnings per share (EPS) for Mori Corporation is $1.22 (rounded), determined by the following calculation:
EPS of $1.22 is more realistic than a figure determined by using 1.4 million shares, the number of common shares outstanding at year-end. Using 1.4 million shares would decrease EPS and would be based on the assumption that the firm had used for the entire year of the cash from the additional stock issued on April 1 and September 30.
Calculating Earnings per share (EPS) for More Complex Capital Structures
Many large corporations have what is referred to as complex capital structures. A complex capital structure contains certain types of bonds, preferred stock, or other securities that are convertible into common shares. These types of convertible securities are often dilutive, because if they were converted into common stock, increasing the number of common shares outstanding, EPS could be reduced. Accounting rules require that when a firm has a complex capital structure, two separate EPS figures must be calculated, primary EPS and fully diluted EPS.
The overall goal of accounting practice concerning earnings per share (EPS) is to measure the increase in equity claims per common share that arose from operating events and other income-related activities in the given time period. While this task might appear simple, it can be complex because of two major factors.
First, many types of securities and other contractual agreements have potentially significant effects on the number of shares of common stock. Examples are stock warrants, convertible bonds, and convertible preferred stock. Second, creating uniformity among all firms led to a far-reaching specification of assumptions that all firms are required to make, even if they do not really describe each individual firm’s situation. Consequently, the EPS information presented on the income statement may be pro forma, or as if certain events occurred that really did not take place. For example, it may be necessary to assume that convertible debt was converted even though it actually was not.
Suppose a company’s net income was $15,000,000 and $3,000,000 paid to preferred stockholders. The company issued 19,000,000 outstanding shares. Calculate the earnings per share.
First, we need to calculate Total Earnings to common shareholders.
Total Earning = Net income – Preferred dividends
Total Earnings = $15,000,000 – $3,000,000 = $12,000,000
Now, The earnings per share are:
EPS = Total Earnings / Outstanding shares
EPS = $12,000,000 / 19,000,000 = $0.63
To illustrate the calculation of both primary and fully diluted EPS, assume that The GAAP Corporation, which earned net income of $2.5 million during 2019, has the capital structure portrayed in Exhibit ‘A’. There are two separate issues of convertible preferred stock. Both are potentially dilutive, but we are assuming that only the 8% preferred stock is considered a common stock equivalent under the current accounting pronouncements. The 6% preferred stock is not a common stock equivalent.
Exhibit ‘B’ shows how primary and fully diluted EPS are calculated. In calculating primary EPS, net income available to common shareholders is determined by subtracting only the dividends on the 6% preferred stock — which is not a common stock equivalent—from the reported net income. The 8% preferred stock——which is a common stock equivalent—is assumed to be converted into shares of common stock, and thus these dividends need not be subtracted from net income.
As a result, net income available to common shareholders is $2,410,000. The weighted average number of common shares at year-end is determined by adding the 1 million outstanding in shares of common to the number of common shares that would be issued if the 8% preferred shares were converted. (Conversion is assumed to take place at the beginning of the year.) Because each of the 20,000 preferred shares is convertible into 5 common shares, an additional 100,000 shares would be issued. Thus the adjusted number of common shares is 1.1 million, and primary EPS is $2.19.
In calculating fully diluted EPS, we assume that all the convertible preferred shares, whether or not common stock equivalents, are converted into common shares. Thus, no adjustment is made to reported net income because now we assume that no preferred dividends will be paid because all the preferred stock is assumed to have been converted. The weighted average number of common shares is determined by adding the 1 million outstanding shares of common to the number of shares that would be issued if both the 8% and 6% preferred shares were converted at the beginning of the year. The adjusted number of common shares is 1.25 million, and fully diluted EPS is $2.
Presenting Earnings per Share (EPS) on Corporate Income Statements
All publicly held corporations are required to present EPS data. on their income statements. Primary EPS must be disclosed, and if fully diluted EPS’is at least 3% less than primary EPS, fully diluted EPS also must be disclosed. EPS data also should be presented for major categories on the income statement, such as income from continuing operations and discontinued operations. Exhibit ‘C’ presents the income statement for the Kroger Company, a large food and drug retailer, including the relevant EPS disclosures.
Uses and Limitations of Earnings Per Share (EPS) Data
Earnings per share (EPS) is a popular financial statistic that provides useful comparisons among companies. lt also provides a basis for other ratios such as the price-earnings ratio. However, one must be extremely careful in using this data. As we noted, the rules for calculating EPS are complex, and it is often impossible for even a sophisticated user to calculate EPS from just looking at published financial data.
Furthermore, if you are relying on published EPS data, you still must be careful. For example, are the published P-E ratios based on primary or fully diluted EPS? Is earnings per share (EPS) from continuing operations used, or is the figure based on other income statement categories? Generally, the P-E ratio is based on primary EPS calculated on income from continuing operations. These are only a few examples of the issues that must be considered in using EPS data.
Relationship between EBIT and EPS
As EPS is an important measure of the company’s performance and it is closely monitored by investors, the finance managers give maximum importance to it while making decisions. It is the risk or the uncertainty factor involved in any decision that makes the managers cautious. In fact, it is the responsibility of managers to enhance the benefits to the shareholders. Since both EBIT and EPS are uncertain, managers cannot decide at once, on a plan with highest EPS. The reason is that a particular plan may provide more EPS at one level of EBIT but less EPS at another level. That means different financing decisions will have varying impact on EPS. It is possible to examine the effects of various financing alternatives through EBIT-EPS analysis.
Let us examine the relationship through an illustration:
A company requires an amount of $800,000 for its proposed expansion program. It is evaluating the following two alternatives financial plans:
If earnings before interest and tax are:
- $120,000 and
- $200,000 and
tax rate applicable to the company is 30%, calculate the impact of EBIT and EPS.
1. When WBIT is $80,000
EPS = Profit to equity holders / Number of equity shares
= 11,200 / 1,600 = 7
= 44,800 / 6,400 = 7
2. When EBIT is $120,000
EPS = Profit to equity holders / Number of equity shares
= 39,200 / 1,600 = 24.5
= 72,800 / 6,400 = 11.3
3. When EBIT is $200,000
EPS = Profit to equity holders / Number of equity shares
= 95,200 / 1,600 = 59.5
= 128,800 / 6,400 = 20.13
Inference: Though the EPS remains the same at $80,000 EBIT level, it can be noticed that the EPS gets increased with an increase in EBIT, but the rate of EPS differs with an EBIT of 120,000 and 200,000 because of difference in the capital structure. Moreover, the influence of fixed cost is not there in this case. In conclusion, EPS increases with the increase in EBIT provided the existing capital structure remains unaltered.