💰Intermediate Financial Accounting II Unit 6 – Earnings Per Share (EPS) Calculation

What's EPS and Why It Matters

• Earnings Per Share (EPS) represents a company's net income allocated to each outstanding share of common stock
• Serves as a key indicator of a company's profitability and is closely watched by investors and analysts
• Allows for comparison of financial performance between companies and across different time periods
• Higher EPS generally indicates better financial health and can positively influence stock prices
• EPS is a required disclosure in a company's financial statements (income statement)
• Helps investors make informed decisions about buying, selling, or holding a company's stock
• Can impact a company's ability to attract investors and raise capital

Basic EPS Formula Breakdown

• The basic formula for calculating EPS is: $\text{EPS} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted Average Common Shares Outstanding}}$
• Net income represents the company's total earnings after subtracting expenses and taxes
• Preferred dividends are subtracted from net income as they take priority over common stock dividends
• Weighted average common shares outstanding accounts for changes in the number of shares during the reporting period
  • Calculated by multiplying the number of shares outstanding by the portion of the reporting period they were outstanding
• The formula provides a straightforward way to determine the earnings attributable to each common share

Types of EPS: Simple vs Complex

• Simple capital structure consists of only common stock and no potentially dilutive securities (convertible bonds, stock options)
  • In this case, basic EPS is the only EPS reported
• Complex capital structure includes potentially dilutive securities in addition to common stock
  • Companies with complex capital structures must report both basic and diluted EPS
• Diluted EPS takes into account the potential conversion of dilutive securities, which can increase the number of common shares outstanding
• The presence of potentially dilutive securities can lead to a lower diluted EPS compared to basic EPS
• Understanding the difference between simple and complex capital structures is crucial for accurate EPS calculation and interpretation

Adjustments for Preferred Dividends

• Preferred dividends must be subtracted from net income before calculating EPS, as they have priority over common stock dividends
• Cumulative preferred dividends accumulate if not paid in a given period and must be paid before any common stock dividends
• Non-cumulative preferred dividends do not accumulate if missed and only the current period's dividend is subtracted from net income
• If preferred dividends are not declared, they are not subtracted from net income for EPS calculation
• The amount of preferred dividends subtracted from net income can significantly impact the final EPS figure

Dealing with Stock Splits and Dividends

• Stock splits and stock dividends increase the number of shares outstanding without affecting the company's total value
  • A 2-for-1 stock split doubles the number of shares outstanding while halving the price per share
• EPS must be adjusted retroactively for stock splits and dividends to maintain comparability across reporting periods
• Retroactive adjustment involves restating the weighted average common shares outstanding for all periods presented
• Failing to adjust for stock splits and dividends can lead to misleading EPS comparisons and trends
• Companies often announce stock splits or dividends to make shares more affordable and attractive to a wider range of investors

Diluted EPS: When and How to Calculate

• Diluted EPS is calculated when a company has potentially dilutive securities (convertible bonds, stock options)
• Diluted EPS assumes the conversion of all dilutive securities into common stock, increasing the number of shares outstanding
• The treasury stock method is used to calculate the number of shares added from stock options and warrants
  • Assumes the proceeds from the exercise of options/warrants are used to repurchase common shares at the average market price
• The if-converted method is used for convertible securities, assuming they are converted at the beginning of the reporting period or at the time of issuance, whichever is later
• Diluted EPS is lower than basic EPS, as it accounts for the potential increase in shares outstanding
• Diluted EPS provides a more conservative measure of a company's earnings per share

Common EPS Calculation Pitfalls

• Failing to properly account for preferred dividends, leading to overstated EPS
• Not adjusting for stock splits or dividends, resulting in incomparable EPS figures across reporting periods
• Improperly applying the treasury stock method or if-converted method for diluted EPS calculation
• Including anti-dilutive securities in the diluted EPS calculation, which would increase EPS and is not permitted
• Using the wrong weighted average common shares outstanding, such as using the ending balance instead of the weighted average
• Neglecting to consider the timing of share issuances or repurchases during the reporting period
• Misclassifying certain items as extraordinary or non-recurring, which can distort EPS

Real-World EPS Analysis and Interpretation

• EPS is a key metric used by investors and analysts to evaluate a company's financial performance and compare it to peers
• Consistent growth in EPS over time can indicate a company's ability to generate increasing profits and create shareholder value
• Comparing a company's EPS to industry benchmarks or competitors helps assess its relative performance
• Analysts often use EPS to calculate the Price-to-Earnings (P/E) ratio, which measures the market's valuation of a company's shares relative to its earnings
• Changes in EPS can significantly impact a company's stock price, as investors react to better-than-expected or worse-than-expected earnings
• It is essential to consider EPS in the context of other financial metrics (revenue growth, profit margins) and qualitative factors (industry trends, competitive landscape) for a comprehensive analysis
• Management may provide EPS guidance to set expectations and communicate their outlook for future performance