CHAPTER 20 Earnings per Share Overview Earnings per share is the most commonly cited and reported measure

of a companys performance. It is reported in the income statement of all public firms. For a firm with a simple capital structure (no potentially dilutive securities), a single earnings per common share presentation (basic EPS) is sufficient. If a firm's capital structure includes securities that could potentially dilute (reduce) earnings per share (such as convertible securities or stock options), it is classified as a complex capital structure and the company must calculate both basic and diluted earnings per share. The effect of each potentially dilutive security is considered by calculating earnings per share as if the security already had been exercised or converted into additional common shares. I. For analysts and the financial press, earnings per share is the most frequently cited and reported measure of a companys performance. A. EPS is reported in the income statement of all publicly traded firms. B. In general, EPS is simply earnings available to common shareholders divided by the weighted average number of common shares outstanding. If a company has no potentially dilutive securities we consider it to have a simple capital structure. A. For a simple capital structure, a single presentation of basic EPS is sufficient. B. If there are no securities other than common stock and the number of common shares remained unchanged, basic EPS is simply net income divided by common shares. When the number of shares changes, EPS calculations are based on the weighted average number of shares outstanding during the period. A. New shares issued during a reporting period are time-weighted by the fraction of the period they were outstanding and then added to the number of shares outstanding for the period. For instance, if 12,000 new shares are sold on October 1, the denominator of the EPS fraction would be increased by: 12,000 x 3/12, or 3,000 shares. B. On the contrary, an increase in shares due to a stock dividend or stock split is not timeweighted. 1. For a stock dividend or stock split, the shares outstanding prior to the stock distribution are restated to reflect the increase in shares. That is, we simply increase the outstanding shares by the number of new shares. 2. The firm would simply have a larger number of less valuable shares (the same pie is cut into more slices). 3. For example, EPS after a 2 for 1 stock split would be half of what it was before, other things being equal. 4. When reported again in the comparative financial statements, previous years EPS are restated for comparability. C. If common shares are reacquired (as treasury stock or to be retired) those shares are timeweighted for the fraction of the period they were not outstanding. The time-weighted shares then are subtracted from the number of shares in the denominator of the EPS fraction. Any dividends on preferred stock outstanding are subtracted from reported net income. A. This is because the denominator in the EPS calculation is the weighted average number of common shares, so the numerator should reflect earnings available to common shareholders. B. This adjustment is made for cumulative preferred stock whether or not dividends are declared that period. The assumption is that eventually the dividends will be paid if the preferred stock is cumulative.

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V.

When a company has securities that could potentially dilute (i.e., reduce) earnings per share, it is classified as a complex capital structure. A. These potentially dilutive securities include stock options and convertible securities. B. The company reports both basic and diluted earnings per share. C. For diluted EPS, the impact of each potentially dilutive security is reflected by calculating earnings per share as if the security already had been exercised or converted into additional common shares. D. Stock options (also stock rights and stock warrants) give their holders the right to exercise their option to purchase common stock, typically at a specified exercise price. The increase in shares would reduce EPS. 1. When calculating diluted EPS, we pretend the stock options had been exercised at the beginning of the period (or at the time the options are issued, if later). 2. We also assume the cash proceeds from the assumed sale were used to buy back (as treasury stock) as many of those shares as could be acquired at the average market price during the period. E. For convertible securities, we pretend for the purpose of calculating diluted EPS that the conversion already has occurred. 1. To include convertible bonds in the calculation of diluted EPS, we pretend the conversion occurred at the beginning of the period (or at the time the convertible security is issued, if later). a. The denominator of the EPS fraction is adjusted for the additional common shares assumed. b. The numerator is increased by the interest (after-tax) that would have been avoided in the event of conversion. 2. To include convertible preferred stock in the calculation of diluted EPS, we pretend the conversion occurred at the beginning of the period (or at the time the convertible security is issued, if later). a. The denominator of the EPS fraction is adjusted for the additional common shares assumed. b. The numerator is increased by the preferred dividends that would have been avoided in the event of conversion. If the effect of the assumed conversion or exercise of potentially dilutive securities would be to increase, rather than decrease, EPS, we consider them antidilutive securities. Antidilutive securities are ignored when calculating both basic and diluted EPS.

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VII. Contingently issuable shares also are potentially dilutive securities. A. These are considered outstanding in the computation of diluted EPS if the conditions for their issuance currently are met. B. For instance, if 50,000 shares will be issued next year if the market price of common shares next year is at least $35 and the market price currently is $36, the 50,000 additional shares would be simply added to the denominator. VIII. Financial statement disclosures include both basic and diluted EPS for both income from continuing operations and net income. A. Per share amounts also are reported for: 1. Discontinued operations, 2. Extraordinary items, and 3. An accounting change. B. Disclosures should include a reconciliation of the numerator and denominator used in the computations.

Decision-Makers Perspective A. Analysts frequently use EPS data in connection with the price-earnings ratio. 1. The P/E ratio is the market price per share divided by the earnings per share. 2. The P/E ratio measures the decision makers' perception of the quality of a companys earnings by indicating the price multiple the market is willing to pay for the firms earnings. 3. In a way, it represents the markets expectation of future earnings as indicated by current earnings taking into account analysts perceptions of a businesss growth potential, stability, and relative risk. B. Another measure, the dividend payout ratio, indicates the percentage of earnings that is distributed to shareholders as dividends.

EARNINGS PER SHARE In the most basic setting, earnings per share is simply a companys earnings (or loss) divided by the number of shares outstanding.

Sovran Metals Corporation reported net income of $154 million in 2000. (Its tax rate was 40%). + Common stock January 1, 2000 60 million shares outstanding (in millions, except per share amount) Basic EPS: net income $154 = $2.57 60 shares outstanding

ISSUANCE OF NEW SHARES If the number of shares has changed, its necessary to find the weighted average of the shares outstanding during the period the earnings were generated. Any new shares issued are timeweighted by the fraction of the period they were outstanding and then added to the number of shares outstanding for the entire period.

Sovran Financial Corporation reported net income of $154 million for 2000 (tax rate 40%). Its capital structure included: Common stock January 1 60 million common shares outstanding March 1 12 million new shares were sold

Basic EPS: (amounts in millions, except per share amount)

net income $154 60 + 12 (10/12) shares new at Jan. 1 shares

$154 = 70 = $2.20

STOCK DIVIDENDS AND STOCK SPLITS The additional shares created by a stock dividend or split are not weighted for the time period they were outstanding. Shares outstanding prior to the stock distribution are retroactively restated to reflect the increase in shares that is, treated as if the distribution occurred at the beginning of the period. Sovran Financial Corporation reported net income of $154 million in 2000 (tax rate 40%). Its capital structure included: Common stock January 1 60 million common shares outstanding March 1 12 million new shares were sold June 17 A 10% stock dividend was distributed Basic EPS: (amounts in millions, except per share amount) net income $154

$154 = = $2.00 77

60 (1.10) + 12 (10/12) (1.10) shares new at Jan. 1 shares ___ stock dividend ___
adjustment

REACQUIRED SHARES The number of reacquired shares is time-weighted for the fraction of the year they were not outstanding, prior to being subtracted from the number of shares outstanding. Sovran Financial Corporation reported net income of $154 million in 2000 (tax rate 40%). Its capital structure included: Common stock January 1 60 million common shares outstanding March 1 12 million new shares were sold June 17 A 10% stock dividend was distributed October 1 8 million shares were reacquired as treasury stock Basic EPS: (amounts in millions, except per share amount) net income $154

$154 = = $2.05

60 (1.10) + 12 (10/12) (1.10) 8 (3/12) 75 shares new treasury at Jan. 1 shares shares ___ stock dividend ___
adjustment*

* not necessary for the treasury shares since they were reacquired after the stock dividend and thus already reflect the adjustment (that is, the shares repurchased are 8 million new shares) EARNINGS AVAILABLE TO COMMON SHAREHOLDERS Preferred dividends are subtracted from net income so that earnings available to common shareholders is divided by the weighted average number of common shares.

Sovran Financial Corporation reported net income of $154 million in 2000 (tax rate 40%). Its capital structure included: Common stock January 1 60 million common shares outstanding March 1 12 million new shares were sold June 17 A 10% stock dividend was distributed October 1 8 million shares were reacquired as treasury stock Preferred stock, nonconvertible January 1-December 31 5 million 8%, $10 par, shares Basic EPS: (amounts in millions, except per share amount) net preferred income dividends $154 $4 * $150 = = $2.00 60 (1.10) + 12 (10/12) (1.10) 8 (3/12) 75 shares new treasury at Jan. 1 shares shares ___ stock dividend ___
adjustment

* 5,000,000 x $10 x 8%

COMPLEX CAPITAL STRUCTURE Potentially dilutive securities Securities that, while not being common stock, may become common stock through their exercise or conversion and, therefore, may dilute (reduce) EPS. Examples: Convertible preferred stock, stock options, rights, or warrants, and contingently issuable securities Complex capital structure If one or more potentially dilutive securities are outstanding A firm with a complex capital structure reports two EPS calculations: Basic EPS ignores the dilutive effect of potentially dilutive securities. Diluted EPS incorporates the dilutive effect of potentially dilutive securities. The dilutive effect is included essentially by pretending the securities already have been exercised, converted, or otherwise transformed into common shares.

OPTIONS, RIGHTS, AND WARRANTS Stock options, stock rights, and stock warrants give their holders the right to exercise their option to purchase common stock, usually at a specified exercise price. The dilution that would result from their exercise should be reflected in the calculation of diluted EPS. Executive stock options Options granted in 1998, exercisable for 15 million common shares* at an exercise price of $20 per share. The average market price was $25. *adjusted for the stock dividend Basic EPS (amounts in millions, except per share amounts) net preferred income dividends $154 $4 $150 = = $2.00 60 (1.10) + 12 (10/12) (1.10) 8 (3/12) 75 shares new treasury at Jan. 1 shares shares ___ stock dividend ___
adjustment

Diluted EPS net preferred income dividends $154 $4 $150 ____________________________________________________________________ 60 (1.10) + 12 (10/12) (1.10) 8 (3/12) + (15 12a) 78 shares new treasury exercise at Jan. 1 shares shares of options __ stock dividend ___
adjustment a Shares

= _____ = $1.92

Reacquired for Diluted EPS 15 million shares x $20 (exercise price) $300 million $25 (average market price) 12 million shares reacquired CONVERTIBLE SECURITIES

For Diluted EPS, conversion into common stock is assumed to have occurred at the beginning of the period (or at the time the convertible security is issued, if thats later). The denominator of the EPS fraction is increased by the additional common shares that would have been issued upon conversion. The numerator is increased by the interest (after-tax) or preferred dividends that would have been avoided if the convertible securities had not been outstanding due to having been converted.

CONVERTIBLE BONDS Common stock January 1 60 million common shares outstanding March 1 12 million new shares were sold June 17 A 10% stock dividend was distributed October 1 8 million shares were reacquired as treasury stock [The average market price during 2000 was $25 per share.] Preferred stock, nonconvertible January 1-December 31 5 million 8%, $10 par, shares Executive stock options Options granted in 1998, exercisable for 15 million common shares* at an exercise price of $20 per share Convertible bonds 10%, $300 million face amount issued in 1999, convertible into 12 million common shares* *adjusted for the stock dividend

Basic EPS (amounts in millions, except per share amounts) $2.00 as before Diluted EPS net income $154 $4 preferred after-tax dividends interest savings + $30 - (40% x $30) $168 = 60 (1.10) + 12 (10/12) (1.10) 8 (3/12) + (15 12) + 12 shares new treasury exercise conversion at Jan. 1 shares shares of options of bonds
adjustment*

= $1.87

90

___ stock dividend ___

CONVERTIBLE PREFERRED STOCK In addition to other elements of the capital structure: Preferred stock, convertible 10 million, 8%, cumulative, $10 par, shares issued in 1996, convertible into 5 million common shares* *adjusted for the stock dividend

Basic EPS (amounts in millions, except per share amounts) net preferred preferred income dividends dividends $154 $4 $8 $142 = 60 (1.10) + 12 (10/12) (1.10) 8 (3/12) shares new treasury at Jan. 1 shares shares ___ stock dividend ___
adjustment

= $1.89

75

_____________________________________ Diluted EPS net preferred preferred after-tax preferred income dividends dividends interest savings dividends $154 $4 $8 + $30 - (40% x $30) + 8 $168 = 60 (1.10) + 12 (10/12) (1.10) 8 (3/12) + (15 12) + 12 + 5 95 shares new treasury exercise conv. conversion at Jan. 1 shares shares of options of of preferred bonds shares ___ stock dividend ___
adjustment

= $1.77

ANTIDILUTIVE SECURITIES At times, the effect of the conversion or exercise of potentially dilutive securities would be to increase, rather than decrease, EPS. These we refer to as antidilutive securities. Such securities are ignored when calculating diluted EPS.

Stock warrants Warrants granted in 1999, exercisable for 4 million common shares* at an exercise price of $32.50 per share *adjusted for the stock dividend Calculations: The calculations of both basic and diluted EPS are unaffected by the warrants because the effect of exercising the warrants would be antidilutive.

The $32.50 exercise price is higher than the market price, $25, so to assume shares are sold at the exercise price and repurchased at the market price would mean reacquiring more shares than were sold.

FINANCIAL STATEMENT PRESENTATION Basic and diluted EPS data are reported on the face of the income statement for all periods presented. Companies without potentially dilutive securities present basic EPS only. Disclosure notes should provide additional disclosures including: A reconciliation of the numerator and denominator used in the basic EPS computations to the numerator and the denominator used in the diluted EPS computations. Any adjustments to the numerator for preferred dividends. Any potentially dilutive securities that werent included because they were antidilutive. Any transactions that occurred after the end of the most recent period that would materially affect earnings per share.

When the income statement includes one or more items that require separate presentation within the statement, EPS data (both basic and diluted) must also be reported separately for income from continuing operations and net income. Per share amounts for discontinued operations, extraordinary items, and the cumulative effect of an accounting change are disclosed either on the face of the income statement or in the notes to financial statements.