Capital Structure

What is Earnings Per Share? How is it calculated?

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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.

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What is WACC? How do you calculate it?

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While valuing an organization using Discounted Cash Flow (DCF), forecasted Free Cash Flow (FCF) is discounted by the Weighted Average Cost of Capital (WACC). WACC represents the opportunity cost of capital for investors when they allocate their funds towards a business.

WACC can be calculated using the following formula:

WACC = D/V x Kd (1 – T) + E/V x Ke

Where,

D/V = Debt to Enterprise Value (EV) based on market value

E/V = Equity to EV based on market value

Kd = Cost of debt

Ke = Cost of equity

T = Company’s tax rate

None of the above components are readily available. Hence, we use various models, assumptions and approximations to arrive at each of the values. There are 3 important factors that need further attention.

  • Cost of equity is depended on (1) Risk-free rate (2) Market risk premium and (3) Beta. We employ CAPM to estimate the cost of equity.
  • After-tax cost of debt depends on (1) Risk-free rate (2) Default spread and (3) Marginal tax rate. For an investment grade company, we employ yield to maturity (YTM) on its long-term debt, and for a public company, we use YTM on bonds’ cash flows and price.
  • Capital Structure (proportion of debt and equity to the EV). The target capital structure is derived by the company’s current debt-to-value ratio. We always use the market values (and not the book values).

Couple of points noteworthy:

  1. WACC based models works well when a company maintains a relatively stable debt-to-value ratio. But for a LBO, it can understate or overstate the impact of the tax shield. In such a situation, we should discount the FCF at unlevered cost of equity and value tax shields separately.
  2. If a company’s debt-to-value ratio changes, we use Adjusted Present Value (APV).

Let’s take an example. Consider a startup wants to raise a capital of $1 million so that it can buy office space and equipments needed to run its business. The company issues 6,000 shares at $100 each to raise $600,000. The shareholders expect a return of 10% on their investment. So, the cost of equity is 10%.

The company then issues 400 bonds of $1,000 each to raise $400,000. The bondholders expect a return of 8%. So, the cost of debt is 8%.

Now, the startup’s total market value ($600,000 equity + $400,000 debt) = $1 million. Let’s assume its tax rate is 35%. So, the company’s WACC is 6%

(($600,000/$1,000,000) x 0.1) + [(($400,000/$1,000,000) x .08) x (1 – 0.35))] = 0.0598 ~6%

This means that for every $1 the start-up raises from its investors, it must return $0.06 to them.

You may also want to read about Enterprise Value here.

Where do I find company’s capital structure?

Nitin Garg1 Comment

A company’s financial health is indicated by the balance sheet, and can be evaluated by 3 broad categories:

  1. Working Capital
  2. Asset Performance, and
  3. Capital Structure

Capital structure depicts a company’s debt and equity mix. A healthy proportion of equity and debt represents a healthy capital structure. Equity capital consists of Preferred Stock, Common Stock and Retained Earnings, which are summed up to form ‘Total Shareholder’s Equity’ in the Balance Sheet. Debt Capital generally comprises of short-term borrowings, long-term debt and current portion of the long-term debt. Equity capital is always costlier than the debt capital because the company shares its profit with the investors. The debt capital burdens the company with periodic interest payments, but the owners earn a tax rebate on the interest, with no profit sharing with the debt holders. But a highly leverage company can become a watchdog since the investors put restrictions to its activities. During economic downturn, if a competitive business is not able generate enough cash flows from its operations, it might have to file Chapter 11 Bankruptcy.

There is no magical debt levels defined. A company debt-to-equity ratio varies according to its stage of development, industry it operates in, and the lines of businesses it has. Analyst use various debt measuring ratios (debt-equity ratio, leverage ratio, EBITDA/interest, liquidity ratio, solvency ratio, to name a few) to analyze the financial health of the company. Various credit rating companies (like S&P, Moody’s, Fitch) evaluate a company’s ability to repay the principal along with the interest on debt obligations before awarding any rating. Capital Structure affects EPS (earnings per share) depending on whether it’s simple or complex. If the company has dilutive securities (complex capital structure), its diluted EPS is lower than the basic EPS; if it’s simple, then basic EPS equals diluted EPS.

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