Chapter 20

Earnings Per Share

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-2

Earnings Per Share (EPS)

Of the myriad of facts and figures generated

by accountants, the single accounting
number that is reported most frequently in
the media and receives by far the most
attention by investors and creditors is
earnings per share.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-3

Basic Earnings Per Share

*Current period’s cumulative preferred stock
Simple Capital dividends
Structure (whether or not declared) and
(Basic EPS)
noncumulative preferred stock dividends
(only if declared).

Net income (after tax) – Preferred dividends*

Weighted average outstanding common stock

Number of shares outstanding

× Number of months outstanding ÷ 12
Weighted average shares outstanding

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-4

Earnings Per Share

A company had 200,000 shares of $50 par value
common stock, 10,000 shares of 5%, $20 par value
cumulative preferred stock, and 30,000 shares of 5%,
$10 par value noncumulative preferred stock
outstanding during the year. Net income after taxes
was $1,500,000. No dividends were declared during
the year. EPS would be
a. $7.50
b. $7.43
c. $7.45
d. $7.38
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.
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20-5

Earnings Per Share

A company had 200,000 shares of $50 par value
common stock, 10,000 shares of 5%, $20 par value
cumulative preferred stock, and 30,000 shares of 5%,
$10 par value noncumulative preferred stock
outstanding during the year. Net income after taxes
was $1,500,000. No dividends were declared during
the year. EPS would be
a. $7.50 $1,500,000 – (10,000 × 5% × $20 par)
b. $7.43 200,000 shares
c. $7.45 Since dividends were not declared, only
the cumulative preferred stock dividends
d. $7.38 are subtracted.
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.
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20-6

Issuance of New Shares

Compute the weighted average number of
shares of common stock outstanding.

Date Description No. of Shares

1/1 Balance 100,000
4/1 Issued 50,000
10/1 Issued 10,000

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-7

Issuance of New Shares

Compute the weighted average number of
shares of common stock outstanding.
Months Weighted
Date Description No. of Shares Outstanding Shares
1/1 Balance 100,000 12/12 100,000
4/1 Issued 50,000 9/12 37,500
10/1 Issued 10,000 3/12 2,500
Weighted average shares outstanding 140,000

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-8

Stock Dividends and Stock Splits

Common shares issued as part of stock
dividends and stock splits are treated
retroactively as subdivisions of the
shares already outstanding at the date
of the split or dividend.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-9

Stock Dividends and Stock Splits

Compute the weighted average number of
shares of common stock outstanding.

Date Description No. of Shares

1/1 Balance 100,000
4/1 Issued 50,000
5/1 Stock dividend(100%) 150,000
10/1 Issued 10,000

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-10

Stock Dividends and Stock Splits

Compute the weighted average number of
shares of common stock outstanding.

1/1 Balance 100,000 12/12 100,000

4/1 Issued shares 50,000 9/12 37,500
5/1 100% stock dividend
Retroactive to 1/1 100,000 12/12 100,000
Retroactive to 4/1 50,000 9/12 37,500
10/1 Issued shares 10,000 3/12 2,500
Weighted average shares outstanding 277,500

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-11

Stock Dividends and Stock Splits

Retroactive treatment:
New shares
issued this period?
Yes No

Stock
Stock dividend
dividend or or split
split is
is Stock
Stock dividend
dividend or or split
split
applied
applied retroactively
retroactively in in is
is treated
treated asas
proportion
proportion toto the
the number
number of of outstanding
outstanding from from the
the
shares
shares outstanding
outstanding at at the
the time
time beginning
beginning of of the
the period.
period.
of
of the
the dividend
dividend or or split.
split.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-12

Reacquired Shares

The
The weighted
weighted average
average number
number of of shares
shares isis
reduced
reduced byby the
the number
number of of reacquired
reacquired
shares,
shares, time-weighted
time-weighted for
for the
the fraction
fraction of
of the
the
year
year they
they were
were not
not outstanding
outstanding..

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-13

Reacquired Shares
Compute the weighted average number of
shares of common stock outstanding.

Date Description No. of Shares

1/1 Balance 100,000
4/1 Issued 50,000
5/1 Repurchased shares 12,000
10/1 Issued 10,000

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-14

Reacquired Shares
Compute the weighted average number of
shares of common stock outstanding.
Months Weighted
Date Description No. of Shares Outstanding Shares
1/1 Balance 100,000 12/12 100,000
4/1 Issued 50,000 9/12 37,500
5/1 Reacquired (12,000) 8/12 (8,000)
10/1 Issued 10,000 3/12 2,500
Weighted average shares outstanding 132,000

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-15

Diluted Earnings Per share

Complex Capital Structure
(dual EPS)

Potentially dilutive securities:

•Stock options, rights, and warrants
Equity Convertible
•Convertible bonds and stock
contracts securities
•Contingent common stock issues

Contingently Treasury If-converted

issuable stock method method
shares

Dilution/Antidilution Test

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-16

Complex Capital Structure

Dual presentation of Earnings Per Share:

Basic EPS
Diluted EPS

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-17

Options, Rights, and Warrants

The treasury stock method
assumes that proceeds from Proceeds
the exercise of equity At
contracts are used to purchase average Used to
treasury shares. This method market
price
usually results in a net
increase in shares included in Purchase
treasury
the denominator of the shares
calculation of diluted
earnings per share.
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.
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20-18

Options, Rights, and Warrants

Determine new shares from assumed
exercise of equity contract.
Compute shares purchased for the treasury.

Proceeds
Proceeds from
from assumed
assumed exercise
exercise
Average
Average market
market price
price of
of stock
stock

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-19

Options, Rights, and Warrants

Determine new shares from assumed
exercise of equity contract.
Compute shares purchased for the treasury.
Compute the incremental shares assumed
outstanding.
New shares from assumed exercise (1)
Less: Treasury shares assumed purchased (2)
Net increase in shares outstanding (3)
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.
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20-20

Options, Rights, and Warrants

When
When the
the exercise
exercise price
price
exceeds
exceeds the
the market
market
price,
price, the
the options
options are
are
antidilutive
antidilutive..

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-21

Treasury Stock Method

Common stock outstanding was 100,000 shares.
Options to purchase 5,000 shares of common
stock were outstanding at the beginning of the
year. The options can be exercised to purchase
stock at $50 per share. The average market
price of the stock was $80. The net increase in
the dilutive earnings per share denominator is
a. 25,000 shares
b. 5,000 shares
c. 3,125 shares
d. 1,875 shares

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-22

Treasury Stock Method

Common stock outstanding was 100,000 shares.
Options to purchase 5,000 shares of common
stock were outstanding at the beginning of the
year. The options can be exercised to purchase
stock at $50 per share. The average market
price of the stock was $80. The net increase in
the dilutive earnings per share denominator is
a. 25,000 shares New shares = 5,000
b. 5,000 shares Treasury shares = 3,125
c. 3,125 shares (5,000 × $50) ÷ $80
d. 1,875 shares Incremental shares = 1,875
(5,000 - 3,125)
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.
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20-23

Next: Convertible Securities

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-24

Convertible Securities
The if-converted method is used for
Convertible debt and equity
securities
The method assumes conversion occurs as of
the beginning of the period or date of
issuance, if later.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-25

Convertible Securities
The assumed conversion of convertible
bonds or preferred stock has two effects on
dilutive earnings per share:
 Increases the denominator by the number of
common shares issuable upon conversion.
 Increases the numerator by decreasing after-tax
interest expense on convertible bonds, and
dividends on convertible preferred stock.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-26

Convertible Securities
Dilutive earnings per share may decrease or
increase after the assumed conversion.
IfIf dilutive
dilutive earnings
earnings per
per share
share decreases
decreases,,
the
the securities
securities are
are dilutive
dilutive and
and are
are
assumed
assumed converted
converted..
IfIf dilutive
dilutive earnings
earnings per
per share
share increases
increases,,
the
the securities
securities are
are antidilutive
antidilutive and
and are
are
not
not considered
considered converted.
converted.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-27

If-Converted Method
Assume net income (after tax) of $500,000,
cumulative convertible preferred stock
dividends of $25,000, common stock
outstanding of 50,000 shares, and a tax rate of
30%. The convertible preferred stock is
convertible into 5,000 shares of common stock.

Is the convertible preferred stock dilutive?

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-28

If-Converted Method
EPS without conversion:
$500,000 – $25,000 = $9.50 EPS

50,000
If the preferred shares
stock is converted, we would not have
dividends and the number of shares of common stock would
increase by 5,000 shares. There is not a tax effect.
EPS after
assumed
conversion:
$500,000 – $0
55,000 shares
= $9.09 EPS Dilutive.
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.
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20-29

If-Converted Method
Assume net income (after tax) of $500,000,
convertible bonds with interest expense of
$50,000, common stock outstanding of
50,000 shares, and a tax rate of 30%. The
bonds are convertible into 2,000 shares of
common stock.
Are the convertible bonds dilutive?

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-30

If-Converted Method
EPS without conversion:
$500,000 = $10.00 EPS
50,000 shares
If the bonds are converted, net income would increase by
$35,000 (after taxes) and the number of shares of common
stock would increase by 2,000 shares.
EPS after assumed
conversion:
$535,000 No, they are
= $10.29 EPS antidilutive.
52,000 shares
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.
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20-31

Order of Entry for Multiple

Convertible Securities
When a company has more than one
potentially dilutive security, they
are considered for inclusion in
dilutive EPS in sequence from the
most dilutive to the least dilutive.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-32

Contingently Issuable Shares

Contingent
Contingent shares
shares are
are issuable
issuable in
in the
the
future
future for
for little
little or
or no
no cash
cash consideration
consideration
upon
upon the
the satisfaction
satisfaction of
of certain
certain
conditions.
conditions.

Future
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.
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20-33

Contingently Issuable Shares

Contingent
Contingent shares
shares are
are included
included in
in
dilutive
dilutive EPS
EPS if:
if:

Shares
Shares are
are issued
issued Some
Some target
target performance
performance
merely
merely due
due to to passage
passage level
level has
has already
already been
been
of
of time.
time. met
met and
and is
is expected
expected toto
continue
continue toto the
the end
end of
of the
the
contingency
contingency period.
period.
Example:
Example: Additional
Additional shares
shares may
may be
be
issued
issued based
based on
on future
future earnings.
earnings.
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.
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20-34

Contingently Issuable Shares

Contingent shares are considered

outstanding common shares and are
included in basic EPS as of the date that all
necessary conditions have been satisfied.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-35

Summary

Dilutive Effect Shown?

Potential Common Shares Basic EPS Diluted EPS
Stock options (or warrants, rights) no yes
Convertible securities (bonds, notes,
preferred stock) no yes
Contingently issuable shares no yes

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-36

Summary
Impact
Potential Common Shares Numerator Denominator
Add incremental
Stock options (or warrants, rights)
None shares
Add shares
Convertible bonds or notes Add after tax issuable upon
interest conversion
Add shares
Convertible preferred Add back issuable upon
dividends declared conversion
Contingently issuable shares
Add shares
Conditions being currently met
None issuable
Conditions not being met None None

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

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20-37

Financial Statement Presentation of

EPS Data
 Income from continuing operations.
 Discontinued operations.
 Extraordinary items.
 Cumulative effect of change in accounting
principle.
 Net income.
Earnings per share values are desirable (but
not required) for extraordinary items and
discontinued operations.
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.
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End of Chapter 20

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.