FA3Lesson 9. Earnings per share

1. Basic earnings per share

2. Diluted earnings per share

3. Diluted earnings per share in a loss year

1. Basic earnings per share

Income available to common shareholdersWeighted average common shares outstanding

- Presented before and after extraordinary item and discontinued operations

Income available to common shareholders= Net income- Preferred dividends declared (or requirement)+/- “gains/losses” on retirement of preferred

sharesEXAMPLE: A21-1

1. Basic earnings per share

Wtd average common shares outstanding= common shares outstanding at year end only if

common shares outstanding has not changed during the year

• Normal share issues/retirements are weighted by time after they happened

• Shares issued from a stock split/dividend are backdated (assumed to have been issued at the beginning of the year and back through all prior years as well)

EXAMPLE: A21-2

2. Diluted earnings per share

Diluted earnings per share might be necessary if the company has a complex capital structure (convertible bonds or preferred shares, outstanding stock options).

Diluted earnings per share is meant to show the maximum potential dilution effect on EPS if convertible securities/options were exercised. Take a “worst case” approach, i. e., include in calculation only the effects of instruments that will reduce (dilute) EPS.

Calculating diluted EPS

Potentially dilutive items can affect the numerator and/or denominator of EPS:

Numerator: a convertible security that is converted can increase income available to common shareholders by eliminating associated interest charges or preferred dividends

Denominator: the conversion or exercise of a potentially dilutive item will increase the number of common shares outstanding

Effect on EPS of potentially dilutive items

Effect on numerator

Effect on denominator

Options None + shares issued-shares retired

Convertible bonds

+ after-tax interest avoided

+ shares issued

Convertible preferred shares

+ dividend claim avoided

+ shares issued

Calculating diluted EPS

1. Start with basic EPS before extraordinary items and discontinued operations

2. Calculate effect of in-the-money options exercised during the period as if exercised at the beginning of the period or initial issue, whichever is later (treasury stock method)

3. Calculate effect of in-the-money options outstanding at end of period as if exercised at beginning of period or initial issue, whichever is later (treasury stock method); calculate subtotal here

Treasury stock methodUsed for written call options and equivalents.

1. Options/warrants are issued at the beginning of the year (or date of issue if later).

2. Proceeds from exercise of option are used to purchase and retire common shares at the average market price during the year.

If option is in the money, company “issues” more shares than it can “retire” – option is dilutive. If option is out of the money, option is antidilutive.

Calculating diluted EPS

4. Calculate effect of debt or preferred shares converted during period as if exercised at beginning of period or initial issue, whichever is later

5. Calculate effect of conversion of debt or preferred shares outstanding at end of period, as if exercised at the beginning of the period or initial issue, whichever is later

6. Rank items from (4) and (5) from most dilutive to least dilutive

Calculating diluted EPS

7. Include effects of items in (4) and (5) in subtotal from (3) in cascading order. Exclude anti-dilutive items.

8. Lowest calculation = diluted EPS

9. Repeat same calculations with net income as basis. Use same adjustments as for EPS before discontinued operations/extraordinary items (no further test for anti-dilution)

3. Diluted EPS in a loss year

• Any increase in the number of shares, or any interest, dividends, or capital charges added back, will generally reduce the loss per share (i. e., virtually all financial instruments are anti-dilutive in a loss year)

• Therefore, in a loss year basic EPS is generally equal to diluted EPS

• A21-24, A21-23, A21-28