When you analyze a company’s financial health, the very first measure that you may want to check is profitability. The portion of a company’s profit allocated to each outstanding share of common stock is known as Earnings Per Share or EPS. Though the interpretation of Earnings Per Share is relatively easy, however, the EPS calculation is not this simple. For example, let us have a look at the Colgate Palmolive Earnings Per Share Schedule.

source – Colgate 10K filings

We note that there are two variations of EPS – **Basic EPS and Diluted EPS **in Colgate**.** Also note that **stock options and restricted stock units** are affecting the total number of shares outstanding. If this is slightly confusing at this stage, then worry not, the primer on EPS cover the basics and then take you to the advanced level of Earnings Per Share. Topics covered are as per below –

- What is Earnings Per Share
- Simple vs Complex Capital Structure
- Basic Earnings Per Share or Basic EPS Definition
- Calculating Weighted Average Number of Shares
- Stock Dividends & Stock Splits
- What is Diluted EPS?
- Effect of Convertible Debt on Basic & Diluted EPS
- Effect of Convertible Preferred Stock on Basic & Diluted EPS
- Treasury stock method – Options & Warrants
- Colgate’s Earning Per Share Analysis
- How Earnings Per Share is related to Stock Markets?

## What is Earnings Per Share or EPS?

Most commonly used corporate profitability measure for publicly traded firms. Earnings per share (EPS) tells common shareholders how much of the available income is associated with the shares they own (their share of the pie).

Important points to note about EPS

- EPS is only reported for shares of common stock
- Non publicly traded firms are not required to disclose EPS numbers
- EPS provides insight to common shareholders about:
- Future dividend payout
- The value of their shareholdings

## Simple versus Complex Capital Structure

A company’s capital structure is **simple **if it consists of **only common stock** or includes no potential common stock that upon conversion or exercise could dilute earnings per common share. Companies with simple capital structures only need to report basic EPS.

A **complex capital structure **has securities that could have a dilutive effect on earnings per common share. As of now, think of dilutive effect as those securities that lower the Earnings Per Share.

- Complex capital structure has potentially dilutive securities like options, warrants or convertible securities.
- Companies with complex capital structures must report both basic EPS and diluted EPS.
- Calculation of diluted EPS under a complex capital structure allows the investors to see the adverse impact on EPS if all diluted securities convert into common stock.

Let us look at the Colgate example again in this context. Colgate has a complex capital structure – Why? Reason is that their capital structure contains stock options and restrictive stock units that may increase the number of shares outstanding (denominator). If the number of shares outstanding increases, then the EPS will decrease. Please note in case of Colgate, the number of shares that increase due to stock options and restricted stock units is 9.1 million for the year of 2014.

source – Colgate 10K filings

## Basic Earnings Per Share (EPS) Definition

Basic EPS does not consider the effect of any dilutive securities. Here we use the actual earnings and actual number of issued common shares issued

Basic EPS Formula in a simple capital structure:

The current year’s preferred dividends is subtracted from net income because EPS refers to earnings available to the common shareholder. Common stock dividends are not subtracted from net income.

Let us take the example of Colgate from above example, the Net Income (2013) attributable to Common Shareholders is $2,241 million and common shares outstanding is 930.8 million. EPS of Colgate for 2014 is $2,241 / 930.8 = $2.41

source – Colgate 10K filings

Since the number of common shares outstanding may change over the year, the weighted average is used to compute EPS. The weighted average number of common shares is the number of shares outstanding during the year weighted by the portion of the year they were outstanding. Analysts need to find the equivalent number of whole shares outstanding for the year.

**Three steps to compute the weighted average number of common shares outstanding:**

- Identify the beginning balance of common shares and changes in the common shares during the year.
- For each change in the common shares:
**Step 1 – Compute the number of shares outstanding**after each change in the common shares. Issuance of new shares increases the number of shares outstanding. Repurchase of shares reduces the number of shares outstanding.**Step 2 – Weight the shares outstanding**by the portion of the year between this change and next change: weight = days outstanding / 365 = months outstanding / 12**Step 3 – Sum up to compute the weighted average number**of common shares outstanding.

**Calculate Basic EPS **

Albatross Inc 2007 Net Income – $1,000,000. Additional data provided below

- 100,000 Class A shares preferred cumulative shares, dividend amount $2.00/share
- 50,000 Class B shares preferred non cumulative shares, dividend amount $1.50/share
- No Dividend declared or paid in the current year
- What will be the numerator of basic EPS for Albatross Inc?

**Numerator of EPS = Net Income – Preferred Dividends**

##### Weighted average number of shares calculation

##### Weighted average number of shares are calculated as per below –

## Stock Dividends & Stock Splits

- In computing weighted average number of shares, stock dividends and stock splits are only changes in the units of measurement, not changes in the ownership of earnings. A stock dividend or split shareholders).
- When a stock dividend or split occurs, computation of the weighted average number of shares requires restatement of the shares outstanding before the stock dividend or split. It is not weighted by the portion of the year after the stock dividend or split occurred.
- Specifically, before starting the three steps of computing the weighted average, the following numbers is restated to reflect the effects of the stock dividend/split:
- The beginning balance of shares outstanding;
- All share issuance or purchase prior to the stock dividend or split;
- No restatement is made for shares issued or purchased after the date of the stock dividend or split.

- If a stock dividend or split occurs after the end of the year, but before the financial statements are issued, the weighted average number of shares outstanding for the year (and any other years presented in comparative form) must be restated.

**Calculate the effect of Stock Splits & Stock Dividends**

Calculate the weighted average number of shares for the following –

**Weighted average number of shares are calculated as per below –**

##### Colgate’s Stock Dividends –

As a result of the 2013 Stock Split all historical per share data and numbers of shares outstanding were retroactively adjusted. In 2012, the shares outstanding were 476.1 million and they almost doubled up to 930.8 million due to two-for-one stock split.

source – Colgate 10K filings

## Diluted EPS

If a company has a complex capital structure, it must report two EPS figures: basic EPS and diluted EPS.

The securities could be either dilutive or anti-dilutive. **Anti-dilutive securities **are those which upon conversion or exercise increase earnings per share or reduce loss per share. The likelihood of conversion or exercise of anti-dilutive securities is considered remote.

Diluted EPS shows the maximum potential adverse effect on EPS if dilutive securities convert to common stock. The purpose is to show the “worst case” scenario. Therefore, the computation of diluted EPS does not consider anti-dilutive securities, which increase EPS. In computing diluted EPS, analysts need to check each potentially dilutive security individually to see whether it is dilutive or anti-dilutive. All anti-dilutive securities are excluded and cannot be used to offset dilutive securities.

To compute diluted EPS, start from basic EPS and then remove the adverse effect of all dilutive securities outstanding during the period.

In computing diluted EPS, the adverse effects of dilutive securities are removed by adjusting the numerator and the denominator of the basic EPS formula.

- Identify all potentially dilutive securities: convertible bond, options, convertible preferred stock, warrants, etc.
- Compute the basic EPS. The effect of potentially dilutive securities is not included in the computation.
- Determine the effect of each potentially dilutive security on EPS to see whether it is dilutive or anti-dilutive. How? Compute the adjusted EPS assuming the conversion occurs. If adjusted EPS (>) basic EPS, the security is dilutive (anti-dilutive).
- Exclude all anti-dilutive securities from the computation of diluted EPS.
- Use basic and dilutive securities to compute diluted EPS.

## Effect of Convertible Debt on EPS

**Effect on Numerator**

Upon conversion, the numerator (net income) of the basic EPS formula increases by the amount of interest expense net of tax associated with those increased by the amount of interest expense, net of tax associated with those potential common shares. Why? If converted, there would be no interest for the bond, so income available to common shares will increase accordingly. After-tax interest is used because bond interest is tax deductible while net income is computed on an after-tax basis.

**Effect on Denominator**

Upon conversion, the denominator (weighted average number of shares outstanding) of the basic EPS formula increases by the number of shares created from the conversion, weighted by the time that these shares would be outstanding: number of shares due to conversion = par value of the convertible bond / conversion price.

Before calculating diluted EPS, one needs to check if this security is anti-dilutive. To check whether the convertible debt is anti-dilutive, calculate

If this number is less than basic EPS, convertible debt is dilutive and should be included in calculation of diluted EPS

**EPS Example – Effect of convertible debt **

Calculate the weighted average number of shares for the following –

During 2006, KK Enterprise reported net income of $250,000 and had 100,000 shares of common stock. During 2006, KK Enterprise issued 1,000 shares of 10%, par $100 preferred stock outstanding. In 2006 KK Enterprise issued, at par, 600, $1,000, 8% bonds, each convertible into 100 shares of common stock. Compute the diluted EPS. Assume tax rate – 40%

**Calculation of Diluted EPS**

## Effect of Convertible Preferred Stock

##### Effect on the Numerator

Upon conversion, the numerator of the basic EPS formula would increase by the amount of the preferred dividends. If converted, there would be no dividends for the convertible preferred stock so income available to common shares will increase accordingly. Different from bond interests, preferred dividends are not tax-deductible.

##### Effect on the Denominator

Upon conversion, the denominator of the basic EPS formula would increase by the number of shares created from the conversion, weighted by the time that these shares would be outstanding: number of shares due to conversion = number of convertible preferred shares outstanding x conversion rate. The time outstanding would be the entire year if the preferred stock was issued in a previous year, or a fraction of the year if the preferred stock is issued in the current year.

Before calculating diluted EPS, one needs to check if this security is anti-dilutive

To check whether the convertible preferred stock is anti-dilutive, calculate

If this number is less than basic EPS, convertible preferred stock is dilutive and should be included in calculation of diluted EPS

**Example – Effect of convertible preferred stock on EPS**

During 2006, KK Enterprise reported net income of $250,000 and had 100,000 shares of common stock. During 2006, KK Enterprise issued 1,000 shares of 10%, par $100 preferred stock outstanding, each convertible into 40 shares. Computed the diluted EPS. Assume tax rate – 40%

**Calculation of Diluted EPS**

## Treasury Stock Method – Options and Warrants

Treasury Stock method is used to calculate the impact of dilutive securities like Options and Warrants. Please look at Treasury stock method for in-depth coverage.

## Colgate’s Earnings Per Share Analysis

We note the following in Colgate’s Earnings Per Share schedule

source – Colgate 10K filings

**Basic EPS Calculation Methodology –**Basic earnings per common share is computed by dividing net income available for common stockholders by the weighted-average number of shares of common stock outstanding for the period.**Diluted EPS Calculation Methodology**– Diluted earnings per common share is computed using the treasury stock method on the basis of the weighted-average number of shares of common stock plus the dilutive effect of potential common shares outstanding during the period.**Dilutive potential common shares**include outstanding stock options and restricted stock units.**Anti-dilutive securities –**As of December 31, 2013 , 2012 and 2011 , the average number of stock options that were anti-dilutive and not included in diluted earnings per share calculations were 1,785,032 , 3,504,608 and 3,063,536 , respectively**Stock Split Adjustment –**As a result of the 2013 Stock Split all historical per share data and numbers of shares outstanding were retroactively adjusted.

## How Earnings Per Share is related to the Stock Markets

Earning represents profitability of the company and is considered to be the most important indicator of financial health of the company. Earnings are reported four times a year by the publicly listed companies and we note that research analysts and investors closely follow this earnings season. Growing earnings or EPS is a measure of company’s great performance and in a way a measure of returns for the investor. Infact, EPS is directly to the stock markets by way wide tracked wallstreet PE Muliple or Price/EPS ratio. Lower the PE multiple compared to the Industry average PE, better it is from the point of view of investments and valuations. Stock prices react sharply to quarterly earnings due to the very same connection. For example, below is the share price movement of Blackberry Ltd after quarterly earnings report. Note the sharp movements in the stock prices. Learn more about Enterprise Value and Equity Value here

source – Reuters

## Other Resources that you may like

- CFA Beginners Guide
- Terminal Value Primer
- Top 4 Must Know Investment Banking Charts
- Alibaba IPO Valuation Model

## What next?

If you learned something new or enjoyed the post, please leave a comment below. Let me know what you think. Many thanks and take care. Happy Learning!

Shalin says

Hi,

Firstly, I appreciate the blog you have created. This is one of the tremendous work you have done. I have a little bit query with regards to ‘Calculate the effect of Stock Splits & Stock Dividends’where your answer is 185000 as weighted average common share outstanding, and my answer is 162500. Can you please recalculate the Stock Splits & Stock Dividends on weighted average comm. share outstanding….?

Thanks & Regards,

Shalin

Dheeraj Vaidya says

Hi Shalin,

thanks for the question. I guess you missed the restatement that needs to be done due to 50% stock dividend. The calculation becomes (100,000 x 1.5 x 3/12) + (120,000 x 1.5 x 2/12) + ……

Best,

Dheeraj

alex Wang says

Thanks so much for a clear picture for the EPS evolution.

Alex

Dheeraj Vaidya says

Thanks Alex. 🙂

wilson says

thank you so much, it is so helpful to me

Dheeraj Vaidya says

thanks Wilson!

jenni says

dalam menghitung %perubahan eps, eps mana yang digunakan??

eps dilusian atau eps dasar??

Joan says

I am preparing for a certification exam and your article provided much know leg area beyond what I needed. Thank you.

Dheeraj says

Thanks Joan. I am glad you linked the article.

Regard,s

Dheeraj

mahendra edunoori says

its very interesting and helpful to me. i learned something extra what i knew earlier.

thanking you to share such files.

i hope i can learn many more new things by following you…

Sonal says

Thanks for sch a good and informative post. You mentioned EPS is helpful for investors, analyst. But wont ROE give a better picture of companys performance ?

Binodgopal Mukherjee says

Helpful. Simple. Easy to understand. Thanks for sharing your knowledge.

Regards

Binod

Dennis says

Hi Dheeraj,

Thank you for this elaborate article on EPS. Your style of writing is simple, yet comprehensive.

Dennis

Wall Street Mojo says

Thank you Dennis.

Suman says

Dear Dheeraj,

You articles relating to valuations are very helpful and easy to go thru. And very excellent stuff to learn and horn our valuation skills.

Regards,

Suman Kumar.K

Wall Street Mojo says

Many thanks. I am glad you like these resources 🙂