Earnings per share (EPS) is a key metric used to determine the common shareholder’s portion of the company’s profit. EPS measures each common share’s profit allocation in relation to the company’s total profit. IFRS uses the term “ordinary shares” to refer to common shares.
The EPS figure is important because it is used by investors and analysts to assess company performance, to predict future earnings, and to estimate the value of the company’s shares. The higher the EPS, the more profitable the company is considered to be and the more profits are available for distribution to its shareholders.
Capital structures that do not include potentially dilutive securities are called simple capital structures. On the other hand, complex capital structures include such securities.
Dilutive securities refer to any financial instrument that can be converted or can increase the number of common shares outstanding for the company. Dilutive securities can be convertible bonds, convertible preferred shares, or stock options or warrants.
There are two different types of earnings per share: basic and diluted. Reporting basic EPS is required because it increases the comparability of earnings between different companies. Diluted EPS is required to reduce moral hazard issues.
Without diluted EPS, it would be easier for the management to mislead shareholders regarding the profitability of the company. It is done by issuing convertible securities such as bonds, preferred shares, and stock options that do not require issuing common shares immediately but can lead to issuance in the future.
| Basic EPS | Diluted EPS |
|---|---|
| Shows how much of the company’s earnings are attributable to each common share | Amount of the company’s earnings attributable to each common shareholder in a hypothetical scenario in which all dilutive securities are converted to common shares |
| EPS = (Net income available to shareholders) / (Weighted average number of shares outstanding) | Amount of the company’s earnings attributable to each common shareholder in a hypothetical scenario in which all dilutive securities are converted to common shares |
| Basic EPS is always larger than diluted EPS | Diluted EPS is always smaller than basic EPS |
Net income available to shareholders for EPS purposes refers to net income less dividends on preferred shares. Dividends payable to preferred shareholders are not available to common shareholders and must be deducted to calculate EPS.
There are two kinds of preferred shares that we need to know about: cumulative and non-cumulative. For cumulative preferred shares, the preferred shareholder’s entitlement must always be deducted regardless of whether they are declared or paid.
Only the current period’s dividends should be considered, not any dividend in arrears. For non-cumulative preferred shares, the dividends should only be deducted if the dividend’s been declared.
To determine the total number of common shares, we calculate the weighted average number of ordinary shares outstanding. A weighted average number is used instead of a year-end number because the number of common shares frequently changes throughout the year.
Consider the following example:
Assume that on January 1, 2017, XYZ Company reported the following:
Preferred shares: 1,000,000 authorized, 400,000 issued and outstanding, $4 per share per year dividend, cumulative, convertible at the rate of 1 preferred to 5 common shares.
Common shares: 5,000,000 authorized, 800,000 issued and outstanding, no par value, and no fixed dividend.
Calculate Basic EPS if net income was $2,234,000.
| Net income | $2,234,000 |
| Less: Cumulative preferred dividends | ($1,600,000) |
| Net income available to common shareholders | $634,000 |
In our example, there are no instances of common share issuance or repurchase. Therefore, the weighted average is equal to the number of shares outstanding: 800,000
Credits to : Corporate Finance Institute