Earnings Per Share (EPS)

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Earnings Per Share (EPS)
One of the most frequently used measures of profitability is earnings per share (EPS). Analysts and investors frequently use multiples of EPS, referred to as price-earnings ratios, to value firms. EPS is the only additional financial metric that U.S. GAAP requires firms to disclose on the face of the income statement and is covered explicitly by the opinion of the independent auditor.2 This section briefly describes the calculation of EPS and discusses some of its uses and limitations

Calculating Basic EPS
Firms have simple capital structures if they do not have

•  outstanding convertible bonds or convertible preferred stock that holders can exchange for shares of common stock.
• options or warrants that holders can use to acquire common stock. For such firms, the accountant calculates basic EPS as follows:

The deduction of preferred stock dividends from net income yields net income available to common shareholders, the residual claimants on a firm’s profits.3 The numerator of basic EPS is adjusted for preferred stock dividends because the denominator includes only common shares outstanding. The denominator is a weighted average of common shares outstanding during the period, reflecting new stock issues, treasury stock acquisitions, and similar transactions that occur through the year. Example 1. Cat Corporation had the following capital structure during its most recent year:

Retained earnings changed during the year as follows:

Assume the preferred stock is not convertible into common stock, the firm acquired 1,000 shares of treasury stock on July 1, and no stock options or warrants are outstanding. Then, the calculation of basic earnings per share for Cat Corporation follows

Calculating Diluted EPS with Complex Capital Structure
Firms that have convertible securities and/or stock options or warrants outstanding have complex capital structures. Such firms must present two EPS amounts: basic EPS and diluted EPS. Diluted EPS reflects the dilution potential of convertible securities, options, and warrants. Dilution refers to the reduction in basic EPS that would result if holders of convertible securities exchanged them for shares of common stock or if holders of stock options or warrants exercised them. Firms include in diluted EPS calculations only those securities, options, and warrants that are exercisable and would reduce EPS; income and share dilution effects of equity instruments are excluded from both the numerator and denominator if they are not yet exercisable (for example, options that have not yet vested) or if their conversion would increase EPS (such securities would be referred to as ‘‘out of the money’’ and their effect on EPS as ‘‘antidilutive’’). Accordingly, diluted EPS will always be less than (or equal to) basic EPS. This section describes the calculation of diluted EPS in general terms

Adjustments for dilutive securities and the adjustment to weighted-average number of shares outstanding presume that the dilutive securities are converted to common shares as of the beginning of the year. To calculate diluted EPS, the accountant assumes the conversion of convertible bonds and convertible preferred stock and the exercise of stock options and warrants if their effect would be dilutive. The accountant adds back (1) interest expense (net of taxes) on convertible bonds and (2) dividends on convertible preferred stock the firm subtracted in computing net income attributable to common shareholders. Consistency would suggest that the accountant also add back to net income any compensation expense recognized on the employee stock options. However, U.S. GAAP and IFRS do not stipulate such an addback, but instead require firms to incorporate any unamortized compensation expense on those options into the calculation of the denominator of diluted EPS, as discussed next.
 

In the denominator of the diluted EPS computation, you increase common shares for the additional shares that are presumed to be issued at the beginning of the year (for conversion of bonds, conversion of preferred stock, and the exercise of stock options and warrants). The computation of additional shares due to the exercise of stock options assumes that the firm would repurchase common shares on the open market using an amount equal to the sum of (1) any cash proceeds from such exercise, (2) any unamortized compensation expense on those options, and (3) any tax benefits that would be credited to Additional Paid-in Capital.4 Only the net incremental shares issued (shares issued under options minus assumed shares repurchased) enter the computation of diluted EPS.
 

Example 2. Assume that Dawg Corporation has the same capital structure as Cat Corporation, except the preferred stock of Dawg Corporation is convertible into 1,000 shares of common stock. Also assume that Dawg Corporation has stock options outstanding that holders can currently exchange for 300 incremental shares of common stock.5 The calculation of diluted EPS is as follows:

stock as of January 1. If conversion had taken place, the firm would have had no preferred dividends during the year. Thus, the accountant adds back $500 of preferred dividends to the numerator. The weighted-average number of shares in the denominator increases for the 1,000 common shares the firm would issue on conversion of the preferred stock. The weighted-average number of shares in the denominator also increases for the incremental shares issuable under stock option plans.

Refer to the income statement of PepsiCo in Appendix A. PepsiCo reports basic EPS of $3.96 and diluted EPS of $3.92 for 2012. PepsiCo’s Note 11, ‘‘Net Income Attributable to PepsiCo per Common Share,’’ shows the calculation of its EPS amounts. Basic EPS shows a subtraction from net income for preferred dividends (related to ESOP convertible preferred stock). It also shows a subtraction for the redemption premium that PepsiCo paid when it redeemed some of the outstanding preferred stock.6 For the calculation of diluted EPS, PepsiCo assumes the conversion of the preferred stock as of the beginning of the year, so the numerator adds back the dividends and redemption premium subtracted in the basic EPS calculation. Similarly, the denominator adds additional common shares assumed to be issued under stock option plans and from the convertible ESOP convertible preferred stock

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