Understanding Basic Earnings Per Share | CFA Level I FSA
In this lesson, we’ll explore earnings per share (EPS), its significance, and how to calculate basic EPS. So, let’s dive in and get a better understanding of this important financial metric!
Why Earnings Per Share Matters
Imagine owning 10,000 shares in a company, and a year later, you discover the company’s net earnings increased by 20%. Sounds great, right? But then you find out the number of outstanding shares doubled over the past year. This means your share of the earnings has effectively been reduced, as the proportion of the company’s equity you own has been halved.
A better measure of a company’s profitability is one that takes into account the number of outstanding shares. The earnings per share, or EPS, is one such measure. It is a commonly used corporate profitability performance measure.
What is Earnings Per Share?
EPS is a measure of a company’s profitability, considering the number of outstanding shares. It’s a common performance measure reported for shares of common stock under both IFRS and US GAAP. EPS helps you understand your share of the company’s earnings better.
Simple vs. Complex Capital Structure
A company’s capital structure can be simple or complex, depending on whether it has issued any potentially dilutive securities, like convertible bonds, convertible preferred stock, employee stock options, or warrants:
- Simple capital structure: Contains only common stock, non-convertible debt, and non-convertible preferred stock.
- Complex capital structure: Has issued any potentially dilutive securities.
Companies with simple capital structures report only basic EPS, while firms with complex capital structures must report both basic and diluted EPS.
Calculating Basic EPS
Basic EPS calculation doesn’t consider the effects of dilutive securities. The formula for basic EPS is:
Basic EPS = (Net Income – Preferred Dividends) / Weighted Average Number of Common Shares Outstanding
Let’s walk through an example:
EXAMPLE
At the beginning of the year, Simple Inc. has 50,000 common stock outstanding and 20,000 preferred stock. Another 10,000 common stock was issued by the company on April 1st. On November 1st, the company repurchased 6,000 common stock. The company has a net income of $200,000 for the year and paid $40,000 cash dividends to its common stockholders and $30,000 to its preferred stockholders. Assuming a simple capital structure, what is the basic EPS for the year?
To find the basic EPS:
- Calculate the earnings available to common stockholders: $200,000 – $30,000 = $170,000
- Calculate the weighted average number of common shares outstanding: 56,500
- Compute the basic EPS: $170,000 / 56,500 = $3.01
Impact of Stock Splits and Stock Dividends
Stock splits and stock dividends affect the total number of outstanding shares but don’t change the proportion of ownership for each shareholder. Neither of these actions is considered dilutive or anti-dilutive.
Adjusting Basic EPS for Stock Dividends
Now, let’s revisit our previous example, adding a 10% stock dividend paid on July 1st. We’ll recalculate the basic EPS, considering this new information:
EXAMPLE
With the addition of a 10% stock dividend on July 1st, what is the revised basic EPS for Simple Inc.?
To adjust the basic EPS for the stock dividend, follow these steps:
- Recalculate the number of shares after the 10% stock dividend: 50,000 + (50,000 * 0.1) = 55,000
- Adjust the number of shares issued on April 1st: 10,000 + (10,000 * 0.1) = 11,000
- Recalculate the weighted average number of common shares outstanding: 62,250
- Compute the revised basic EPS: $170,000 / 62,250 = $2.73
As you can see, the basic EPS is now lower, reflecting the stock dividend’s impact on the number of outstanding shares.
Wrapping Up
Understanding basic EPS is crucial for investors as it provides insight into a company’s profitability, considering the number of outstanding shares. It’s important to consider stock splits and stock dividends when calculating basic EPS, as they impact the number of outstanding shares. In our next lesson, we’ll dive into diluted EPS, which takes into account the effects of dilutive securities on earnings per share.
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