Earnings per Share
The Introductory Lecture
for Acct 414
With comparison to IFRS
1
The most closely watched
statistic on Wall Street
Earnings per
share (EPS) is
an important
indicator of the
success or
failure of a
company.
2
Several components of EPS must be
disclosed if there are discontinued
operations, extraordinary items, or
cumulative effects of changes in
accounting principles.
Earnings Per Share:
Continuing operations
$3.15
Discontinued operations
.67
Extraordinary loss
(.15)
Cumulative effect of accounting change .17
Net Earnings Per Share
$3.84
Cumulative effect item pretty much “gone” after SFAS No. 154
3
There may be two EPS
numbers for each item:
Basic
Considers only
common shares
outstanding
Diluted
Reflects the
maximum potential
dilution from all
possible stock
conversions that
would have
decreased EPS.
4
Relation between
Basic and Diluted EPS
5
Diluted earnings per share
I like to think of it as the
‘worst case scenario’
It is the lowest possible number we’d
report for EPS
It is a “proforma” number, not a “fact”
6
Capital structure determines
reporting
Many companies will report basic earnings
per share only
Other companies must report BOTH basic and
diluted earnings per share
It depends on whether the capital structure is
Simple, or
 Complex

7
A simple capital structure consists
of just common stock.
Common
Stock
The corporation has
only common and
nonconvertible
preferred stock.
It has no convertible
securities, stock
options, warrants, or
other rights
outstanding.
8
Capital Structures
Complex Capital Structure:
The corporation has one or
more instruments
outstanding that could result
in issuance of additional
Convertible
common shares.
Preferred
Convertible
Bonds
Stock
Options
9
Capital Structures
Therefore, a company with
potential per share dilution
is considered to have a
complex capital structure.
Note that a potentially
dilutive security does
not necessarily dilute
EPS
10
Dilution of Earnings
Dilutive Securities: Securities whose
assumed exercise or conversion results
in a reduction in earnings per share.
Antidilutive Securities: Securities
whose assumed conversion or exercise
results in an increase in earnings per
share.
11
Basic Earnings Per Share
Net Income - Preferred Dividends
Weighted average number of
common shares outstanding
12
Earnings Per Share Example
A company has the following capital
structure at the end of 2006:



6% Cumulative preferred stock, $100 par
value, issued and outstanding 10,000 shares
Common stock, $10 par, issued 200,000
shares, outstanding 180,000 shares
Treasury stock (20,000 shares at cost of
$18)
13
EPS Example
During 2006, the following transactions
take place:



April 1, 2006 – issued 100,000 shares to
acquire the assets of another company.
Market value of shares was $25
June 30, 2006 – declared and distributed a 2 for 1
stock split effected in the form of a stock dividend
September 1, 2006 – sold 10,000 shares of the
treasury stock for $28 per share
14
Step 1 – find weighted average
shares outstanding
Date
1/1 to 3/31
4/1/2003
4/1 to 6/29
6/30/2003
6/30 to 8/31
9/1/2003
9/1 to 12/31
Common
Stock
200,000
100,000
Common
Shares
Outstanding
20,000
180,000
100,000
Treasury
Stock
Months
Split
Factor
Weighted
3/12
Weighted average
15
Step 1 – find weighted average
shares outstanding
Date
1/1 to 3/31
4/1/2006
4/1 to 6/29
6/30/2006
6/30 to 8/31
9/1/2006
9/1 to 12/31
Common
Stock
200,000
100,000
300,000
Common
Shares
Outstanding
20,000
180,000
100,000
20,000
280,000
Treasury
Stock
Months
Split
Factor
Weighted
3/12
3/12
Weighted average
16
EPS Example
During 2006, the following transactions
take place:



April 1, 2006 – issued 100,000 shares to acquire
the assets of another company. Market value of
shares was $25
June 30, 2006 – declared and distributed a 2
for 1 stock split effected in the form of a
stock dividend
September 1, 2006 – sold 10,000 shares of the
treasury stock for $28 per share
17
Stock Splits & Dividends
All stock splits and
stock dividends must be
incorporated into the
computation of
weighted average
shares outstanding.
This must done for all
periods presented in
the financial
statements.
18
Step 1 – find weighted average
shares outstanding
Date
1/1 to 3/31
4/1/2006
4/1 to 6/29
6/30/2006
6/30 to 8/31
9/1/2006
9/1 to 12/31
Common
Stock
200,000
100,000
300,000
280,000
580,000
Common
Shares
Outstanding
180,000
20,000
100,000
280,000
20,000
280,000
560,000
20,000
Treasury
Stock
Months
Split
Factor
3/12
2
3/12
2
2/12
1
Weighted
Weighted average
19
Stock Splits & Dividends
This year’s EPS figures
may have to be changed
in the future as a result of
stock splits or dividends.
Think about what would
happen if we did NOT
make the adjustment . . .
20
EPS Example
During 2003, the following transactions
take place:



April 1, 2003 – issued 100,000 shares to acquire
the assets of another company. Market value of
shares was $25
June 30, 2003 – declared and distributed a 2 for 1
stock split effected in the form of a stock dividend
September 1, 2003 – sold 10,000 shares of
the treasury stock for $28 per share
21
Step 1 – find weighted average
shares outstanding
Date
1/1 to 3/31
4/1/2006
4/1 to 6/29
6/30/2006
6/30 to 8/31
9/1/2006
9/1 to 12/31
Weighted
average
Common
Stock
200,000
100,000
300,000
280,000
580,000
580,000
Treasury
Stock
20,000
20,000
20,000
-10,000
10,000
Common
Shares
Outstanding
180,000
100,000
280,000
280,000
560,000
10,000
570,000
Months
Split
Factor
3/12
2
3/12
2
2/12
1
4/12
1
Weighted
12/12
22
Step 1 – find weighted average
shares outstanding
shares outstanding Multiply
by fraction of year and by
split factor
Date
1/1 to 3/31
4/1/2006
4/1 to 6/29
6/30/2006
6/30 to 8/31
9/1/2006
9/1 to 12/31
Weighted average
Common
Stock
200,000
100,000
300,000
280,000
580,000
580,000
Treasury
Stock
20,000
20,000
20,000
-10,000
10,000
Common
Shares
Outstanding
180,000
100,000
280,000
280,000
560,000
10,000
570,000
Months
Split
Factor
3/12
2
90,000
3/12
2
140,000
2/12
1
93,333
4/12
1
190,000
513,333
12/12
Make sure you have accounted
for all 12 months and no more
than 12 months!
Weighted
Add
‘em up
23
Step 2 - numerator
Net income = $3,000,000
Preferred dividends =
10,000 shares * $100 * 6% = $60,000
Note: Always include preferred dividend if it is
cumulative preferred stock. If not cumulative, only
include preferred dividend if declared during year
Now let’s plug everything into the formula . . .
24
Step 3 – compute basic EPS
Net income – Preferred dividends
Weighted average shares outstanding
$3,000,000 – $60,000
513,333
 $5.73
25
What if . . .
Taking the same facts, what if the
preferred stock was convertible into 10
shares of common stock at the option
of the stockholder?

This would make it a “complex capital
structure” and we’d have to report both
the basic EPS we computed plus a “diluted
earnings per share” figure.
26
Convertible preferred
The 10,000 shares of preferred could
become 100,000 shares of common
stock (outstanding all year)
We would NOT pay the preferred
dividend because there would be no
preferred stock
27
Diluted EPS
Net income – Preferred dividends
Weighted average shares outstanding
$3,000,000 – $0
513,333 + 100,000
Diluted EPS = $4.89
Both the $5.73 and the $4.89 would be
reported on the face of the income statement
28
Diluted Earnings per Share
For convertible bonds and convertible
preferred stock we use what is called the
If Converted Method
For options, we use the
Treasury Stock Method
For computing dilution, the rate of conversion most
advantageous to the security holder is used (maximum
dilutive conversion rate)
29
The If-Converted Method
The conversion of the securities into common
stock is assumed to occur at the beginning of
the year or date of issue, if later.
Convertible bonds: The interest expense (net
of tax) is added back to net income.
Convertible preferred: No deduction for
preferred dividends.
The weighted average number of shares is
increased by the additional common shares
assumed issued.
30
Treasury Stock Method
Proceeds from conversion are assumed to be
used for purchase of treasury stock at
AVERAGE market price.

Purpose is to acquire treasury stock that can be
reissued to option or warrant holders. If not
sufficient, we’d have to issue MORE shares
Any additional shares issued, over treasury
stock, are added to “weighted- average
shares outstanding.”

Exercise is assumed to occur on the first day of
the year unless issue date is later.
31
Treasury Stock Method-Example: Basic Data
Assume the following:
Net Income
Common Shares Outstanding
(entire year)
Stock Options Outstanding
Exercise Price Per Share on Options
Average Price of Common Shares
$8,000
6,000
2,000
$30
$40
32
Treasury Stock Method--Example
Net income – Preferred dividends
Weighted average shares outstanding
$8,000
Basic EPS =
6,000
Basic EPS = $1.33
33
Treasury Stock Method-Example: 3 steps
1. Options assumed exercised
(2,000*30) = $60,000 cash “received”
2. Shares assumed repurchased with
proceeds ($60,000 / $40) = 1,500
3. Additional shares assumed issued:
2,000 from exercise less 1,500
purchased with proceeds = 500 net
new shares
34
Treasury Stock Method--Example:
Net income – Preferred dividends
= average shares outstanding
Weighted
$8,000
Diluted EPS =
6,000 + 500
= $8,000/6,500 =
Diluted EPS = $1.23
35
Short-cut formula:
Net new shares
=
Number of shares
to which
option holders
are entitled
2,000
*
*
Avg Mkt Price – Option
Price
Avg Mkt Price
$40 - $30
$40
36
Formula for diluted EPS
- Preferred
dividends if + After-tax
Net income preferred bond interest
stock is NOT on converconvertible tible bonds
Weighted average of common shares
assuming maximum dilution
(including options)
37
Getting the lowest possible
number – an algorithm
1. Compute the per share effect of each
potentially dilutive security separately.
2. Make a list from smallest per share number
to largest per share number
3. Compute basic earnings per share
4. For diluted EPS, take the securities into EPS
computation one at a time until the next
item on the list is bigger than the most
recent EPS figure.
38
Earnings per Share
IAS 33 & FAS 128
“High Level Convergence”
versu
s
Disclosures of EPS
IFRS
On face of income
statement


Basic & diluted for income
from continuing operations
AND profit & loss
Profit and loss is the IFRS
term for “net income” in
the US
US GAAP
On face of income
statement

Basic & diluted for income
from continuing operations,
discontinued operations,
extraordinary items and
(formerly) cumulative
effect of change in
accounting principles
Both will be changing in the next few years to
an entirely different looking set of financial
statements!
Computing Diluted EPS
IFRS
Treasury stock method


Uses annual stock prices to
get weighted average
Contracts settled in cash or
shares are assumed to be
settled in shares and
therefore impact diluted
EPS
US GAAP
Treasury stock method


Uses quarterly stock prices
and quarter by quarter in
weighted average
computations
Contracts settled in cash or
shares included if share
settlement is anticipated
Both standard setters are committed to
eliminating these differences