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income statement presented in Figure 4.1 includes earnings per share (EPS), which is $3.75 for the year just ended.
Privately owned businesses whose capital stock shares are not traded in public markets do not have to report their earnings per share, and most don’t. I include it in Figure 4.1 because publicly owned businesses whose capital stock shares are traded in a public marketplace (such as the New York Stock Exchange or Nasdaq) are required to report EPS.
Earnings per share (EPS) is calculated as follows for the business (see Figures 4.1 and 4.2 for data):
$1,585,587 net income available for stockholders
ᎏᎏᎏᎏᎏᎏᎏ
422,823 total number of outstanding capital stock shares
= $3.75 basic EPS
For greater accuracy, the weighted average number of shares outstanding during the year should be used to calculate EPS—which takes into account that some shares may have been issued and outstanding only part of the year. Also, a business may have reduced the number of its outstanding shares during part of the year. I use the ending number of shares to make it easier to follow the computation of EPS.
The numerator (top number) in the EPS ratio is net income available for common stockholders, which equals bottom-line net income minus dividends paid to preferred stockholders of the business. Many business corporations issue preferred stock shares that require a fixed amount of dividends to be paid each year. The total of annual dividends to the preferred stockholders is deducted from net income to determine net income available for the common stockholders.
The business in the example has issued only one class of capital stock shares. It has not issued any preferred stock, so all its net income is available for its common stock shares.
51
F I N A N C I A L R E P O R T I N G
Basic and Diluted EPS
Please notice the word basic in the preceding EPS calculation.
Basic means that the actual number of common stock shares in the hands of stockholders is used as the denominator (bottom number) for calculating EPS. If a business were to issue more shares, the denominator would become larger and EPS
would decrease. The larger number of shares would dilute EPS. In fact many business corporations have entered into contracts that oblige them to issue additional stock shares in the future. These shares have not yet been issued, but the business is legally committed to issue more shares in the future. In other words, there is the potential that the number of capital stock shares will be inflated and net income will have to be divided over a larger number of stock shares.
Many public businesses award their high-level managers stock options that give them the right to buy stock shares at fixed prices. These fixed purchase prices generally are set equal to the market price at the time the stock options are granted. The idea is to give the managers an incentive to improve the profit performance of the business, which should drive up the market price of its stock shares. When (and if) the market value of the stock shares rises, the managers exercise their rights and buy stock shares at the lower prices fixed in their option contracts. Managers can make millions of dollars by exercising their stock options. There is a wealth transfer from the nonmanagement stockholders to some of the management stockholders because the market price per share is lower than it would have been if shares had not been issued to the managers.
The calculation of basic EPS does not recognize the addi-DANGER!
tional shares that may be issued when management stock options are exercised in the future. Also, some businesses issue convertible bonds and convertible preferred stock that at the option of the security holders can be traded in for common stock shares based on predetermined exchange rates.
Conversions of senior securities into shares of common stock also cause dilution of EPS.
To alert investors to the potential effects of management stock
Privately owned businesses whose capital stock shares are not traded in public markets do not have to report their earnings per share, and most don’t. I include it in Figure 4.1 because publicly owned businesses whose capital stock shares are traded in a public marketplace (such as the New York Stock Exchange or Nasdaq) are required to report EPS.
Earnings per share (EPS) is calculated as follows for the business (see Figures 4.1 and 4.2 for data):
$1,585,587 net income available for stockholders
ᎏᎏᎏᎏᎏᎏᎏ
422,823 total number of outstanding capital stock shares
= $3.75 basic EPS
For greater accuracy, the weighted average number of shares outstanding during the year should be used to calculate EPS—which takes into account that some shares may have been issued and outstanding only part of the year. Also, a business may have reduced the number of its outstanding shares during part of the year. I use the ending number of shares to make it easier to follow the computation of EPS.
The numerator (top number) in the EPS ratio is net income available for common stockholders, which equals bottom-line net income minus dividends paid to preferred stockholders of the business. Many business corporations issue preferred stock shares that require a fixed amount of dividends to be paid each year. The total of annual dividends to the preferred stockholders is deducted from net income to determine net income available for the common stockholders.
The business in the example has issued only one class of capital stock shares. It has not issued any preferred stock, so all its net income is available for its common stock shares.
51
F I N A N C I A L R E P O R T I N G
Basic and Diluted EPS
Please notice the word basic in the preceding EPS calculation.
Basic means that the actual number of common stock shares in the hands of stockholders is used as the denominator (bottom number) for calculating EPS. If a business were to issue more shares, the denominator would become larger and EPS
would decrease. The larger number of shares would dilute EPS. In fact many business corporations have entered into contracts that oblige them to issue additional stock shares in the future. These shares have not yet been issued, but the business is legally committed to issue more shares in the future. In other words, there is the potential that the number of capital stock shares will be inflated and net income will have to be divided over a larger number of stock shares.
Many public businesses award their high-level managers stock options that give them the right to buy stock shares at fixed prices. These fixed purchase prices generally are set equal to the market price at the time the stock options are granted. The idea is to give the managers an incentive to improve the profit performance of the business, which should drive up the market price of its stock shares. When (and if) the market value of the stock shares rises, the managers exercise their rights and buy stock shares at the lower prices fixed in their option contracts. Managers can make millions of dollars by exercising their stock options. There is a wealth transfer from the nonmanagement stockholders to some of the management stockholders because the market price per share is lower than it would have been if shares had not been issued to the managers.
The calculation of basic EPS does not recognize the addi-DANGER!
tional shares that may be issued when management stock options are exercised in the future. Also, some businesses issue convertible bonds and convertible preferred stock that at the option of the security holders can be traded in for common stock shares based on predetermined exchange rates.
Conversions of senior securities into shares of common stock also cause dilution of EPS.
To alert investors to the potential effects of management stock
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