Lecture 15 EPS Flashcards
What is earning per share?
Earnings per share (EPS) is defined as
net income/number of common shares outstanding
If the entity has discontinued operations, total EPS is broken down into EPS from continuing operations and EPS from discontinued operations.
Other comprehensive income (OCI) is not included in EPS.
What is the difference between basic and diluted EPS?
Firms report two versions of earnings per share.
Basic EPS is calculated from actual income and actual shares outstanding.
Diluted EPS is a hypothetical value that would obtain if potential ordinary shares (POS) had been issued.
POS arise from outstanding instruments that could be (but have not yet been) converted into additional shares (e.g., options, convertible bonds).
Only conversions that would reduce EPS are included in diluted EPS.
What income specifically is included in EPS?
EPS is based on the income that accrues to common shareholders only.
Any profit share given to equity-like participants other than common shareholders of the entity must be deducted first, including:
- dividends to holders of preferred stock or similar instruments; and
- income to minority (non-controlling) shareholders.
What is counted under the “number of shares” for earnings per share calculation?
Net income is divided by the number of common shares that are outstanding (i.e., in the hands of shareholders) during the period.
Shares repurchased and held as treasury stock are not included.
The number of shares outstanding may change during the period (e.g., due to stock repurchases or issuances).
EPS is based on the average number of shares outstanding over the course of the period, weighted by time.
How are stock dividends and splits treated when calculating EPS?
Sometimes entities issue new shares to existing shareholders without receiving a cash (or other resource) contribution in exchange.
There are two economically equivalent forms.
- Issuances stated as ratios (e.g., receive 2 new shares in exchange for each old share) are referred to as stock splits.
- Issuances stated as percentages (e.g., receive a 20% increase in the number of shares held) are referred to as stock dividends.
In computing EPS, stock splits and dividends are treated retroactively, as if they had occurred on the first day of the period.
How to computed diluted EPS?
To determine diluted EPS, identify all outstanding but unexercised instruments that can be converted into common stock.
For each instrument, determine:
- the number of shares the instrument can be converted into; and
- the change in net income resulting from this conversion (if any).
Then divide the income effect by the number of new shares.
Rank the instruments by this marginal-earnings-per-share metric, from lowest to highest.
Calculate EPS assuming that the highest-ranking instrument has been converted.
Then calculate EPS assuming that the two (three, four,…) highest-ranking instruments have been converted.
Continue as long as the inclusion of more instruments decreases EPS from continuing operations.
Stop once you encounter an instrument that makes EPS increase again. Such instruments are antidilutive and are not included in diluted EPS
What is the treasury stock method?
The diluted EPS calculation assumes that all of the proceeds are used to repurchase shares in the market.
This is called the treasury stock method.
The number of additional shares used in the diluted EPS calculation is the difference between
- the number of shares issued in exchange for the options (or other option-like instruments); and
- the number of shares that could be repurchased with the proceeds, at the entity’s average stock price during the period.
Ignore cases when this difference is negative (out-of-the-money options).
