Earnings Per Share (EPS), an input to Price/Earnings (P/E) ratio, allows the shareholder to calculate his/her share of the company’s earnings. EPS can be classified into two – Basic and Diluted. Calculation of EPS requires that we have information on the company’s capital structure – simplex or complex.
A company is said to have complex capital structure when its securities (like convertible bonds, convertible preferred stock, employee stock options, etc) are convertible into common stock, and a company with no such convertible securities is said to have a simple capital structure. The distinction between the two is important while calculating EPS because any potential convertible securities can dilute (i.e., decrease) it. That’s why accounting standards like IFRS require public companies to disclose both basic and diluted EPS on the income statement.
In this article – Part1, I’ll discuss Basic EPS and in Part2, I’ll cover Diluted EPS.
Part1: Basic Earnings Per Share (Basic EPS)
Basic EPS is the earnings available to the common shareholders divided by the weighted average number of common shares outstanding in a given period of time. This available income is the residual amount after the preferred dividends, if any, are paid.
Basic EPS = (Net Income – Preferred shareholders dividends) / Weighted average number of common shares outstanding
If there is a change in the number of shares outstanding because of stock dividend, stock bonus, or a stock split, the EPS will reflect the change as well.
Example:
Company A has a net income of $3,500,000. As on December 31, 2000, the company has the following information. The company also declared and paid dividends worth $300,000 to its preferred shareholders. What’s their EPS?
Shares outstanding on January 01, 2001 1,000,000
Shares issued: April 01, 2001 300,000
Treasury Shares (stock repurchased): October 01, 2001 (100,000)
Shares Outstanding: December 31, 2001 1,200,000
Calculations
Weighted Average Shares Outstanding
1,000,000 x (3/12 months) = 250,000 (January to March is 3 months)
1,300,000 x (6/12 months) = 650,000 (April to September is 6 months)
1,200,000 x (3/12 months) = 300,000 (October to December is 3 months)
(250,000 + 650,000 + 300,000) = 1,200,000
Basic EPS
($3,500,000 – $300,000) / 1,200,000 = $2.67
If Company A undergoes a 2-for-1 stock split, then each shareholder would receive 2 shares for each current share that s/he owns. For any EPS calculation, stock splits are treated as if it occurred at the beginning of the period.
Weighted Average Common Shares Outstanding would be then …
1,200,000 x 2 = 2,400,000
… and Basic EPS would be
($3,500,000 – $300,000) / 2,400,000 = $1.33
Read Part2: Diluted EPS here
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