0:02

Hello, I'm Professor Brian Bushee and welcome back.

Â In this video, we're going to talk about earnings per share.

Â Seems like it should be an easy video to do.

Â Take earnings, divide by shares, you're done.

Â Except that there are a lot of complications in

Â this calculation, as you'll see.

Â Let's get started.

Â 0:22

Earning per share, or EPS, provides a measure of

Â how much earnings was generated for each share of common stock held by outsiders.

Â So the idea is to take this performance measure earnings and

Â scale it by the number of shares outstanding, so

Â that each share holder can say how much earnings did the company generate for

Â me this period versus the number of shares that I hold.

Â It's extremely common number in finance reporting.

Â So the company often emphasizes this number at the earnings announcement, and

Â then the media often picks up what the EPS was for the companies fiscal period.

Â 1:03

And it's compared to price per share to get this

Â thing called the price-earnings ratio or P/E ratio, which is a quick and

Â dirty evaluation technique that investors use where they have some notion of

Â what the multiple that price should be over earnings.

Â So when you get this EPS number, you multiply it times the multiple and

Â it gives you what the price should be.

Â We're going to start with basic EPS,

Â basic earnings per share which is defined as net income minus preferred dividends.

Â So we take out preferred dividends to try to get some notion of the return for

Â common shareholders.

Â And we divide it up

Â by the weighted average number of common shares outstanding.

Â 1:59

>> No, no. It's okay to

Â talk about weight with shares.

Â So weighted average means that we weigh the average by

Â how long the shares were outstanding.

Â So if we had 10,000 shares outstanding for

Â three quarters of a year, 15,000 shares for one quarter of the year, we would take

Â three fourths of 10,000 plus one fourth of 15,000 to get the weighted average.

Â And we subtract preferred dividends because we're looking at this notion of

Â how much is left for common share holders, so net income already takes out

Â interest expense which are the distributions to bond holders.

Â In addition, we take out the preferred dividends,

Â which don't show up in the income statement,

Â to get this notion of what is leftover for the common stock holders.

Â 2:39

Let's take a look at an example.

Â So for the year ended December 31 2013, Stack reported net income of $25,000.

Â On January 1st, 2013, Stack had 22,000 common shares outstanding,

Â and 10,000 preferred shares outstanding.

Â So that was what they had at the beginning of 2013.

Â 2:58

Stack issued 4,000 new common shares on June 20th, 2013.

Â So they issued more shares in the middle of the year.

Â During the year Stack paid 5,000 preferred dividends, and 9,000 of common dividends.

Â So we're going to try to figure out Stack Incorporated's basic EPS.

Â So, we can start filling in what we know.

Â So net income is $25,000.

Â We subtract 5,000 of preferred dividends.

Â We ignore the common dividends.

Â We don't need them for this calculation.

Â 3:28

Then for the denominator we're looking at for

Â weighted average number of common shares outstanding.

Â So first off, we ignore preferred shares.

Â When we look at the common shares, they had 22,000 shares at the beginning of

Â the year and those are outstanding throughout the year.

Â But then they added 4,000 shares for half a year.

Â So to get the weighted average we take 22,000 shares for

Â the full year, plus they had four thousand shares for half a year.

Â We have 24,000 shares in the denominator and

Â of course we have 20,000 in the numerator of net income minus preferred dividends.

Â Another way that you could try to calculate this denominator would be to

Â think of it as you had 22,000 shares outstanding for

Â half the year from January through the end of June.

Â And then you had 26,000 shares outstanding for

Â half the year from July 1 to December 31.

Â And so if you take half a year at 22,000,

Â half a year at 26,000 you end up with the same 24,000 in the denominator.

Â And so that's going to give us a basic earnings per share of $.83.

Â 4:48

>> I'm not sure the right way to look at earnings per share is in an absolute

Â sense, like over a dollar a share is good, or over a dollar a share is bad.

Â You really want to compare this to other per-share numbers for

Â the company, like prior years' earnings per share, dividends per share,

Â or maybe the most common use is price per share to get this price earnings multiple.

Â So don't think of earnings per share as there's an absolute benchmark.

Â But usually you're trying to meet last year's earning per share or

Â analyst forecast for earnings per share.

Â And then you're really concerned about this ratio of price per share to

Â earnings per share.

Â Hopefully it's high and high within your industry.

Â 5:25

So now we're going to talk about diluted EPS.

Â So companies with complex capital structures also have to

Â report something called diluted EPS.

Â As it turns out, almost every company has one of these instruments.

Â So almost every company reports diluted EPS.

Â And it turns out that diluted EPS is the number that

Â most people focus on rather than basic EPS.

Â So what does a complex capital structure mean?

Â It means that there's securities that can be converted into shares of

Â common stock at the investor's discretion.

Â So this would include things like convertible debt.

Â So an investor holds debt, but

Â they have the option to convert that into shares of stock.

Â Or stock options and warrants.

Â Warrant is another form of stock option, but this gives the holder of the option or

Â the warrant the ability to convert that into new shares of stock.

Â Now, some of the value of these convertible securities is tied to

Â the value of the common stock.

Â You know, basically you, you get a stock option or

Â you get convertible debt and part of the price of getting that

Â incorporates the price of the common stock because there's this option to convert.

Â So in a sense, the investors holding these securities are like indirect stockholders.

Â And we really should count them as at least

Â some fraction of the common shareholders at the time we do the EPS calculation.

Â So what diluted EPS is going to do is give you an EPS number assuming that everything

Â that could convert to a share of stock actually did convert to a share of stock.

Â So the definition's going to be take net income minus preferred dividends, but

Â then add an adjustment for

Â convertibles, what would happen if they converted to common stock.

Â And then in the denominator, we'll take the weighted average common shares

Â outstanding, and again adjust for the effect of these convertibles.

Â Assuming that everything could convert would actually do so.

Â 7:31

Diluted EPS is computed under the assumption that that

Â convertible debt was exchanged for common stock at the beginning of the period.

Â This is called the if converted method, so we'll see an EPS number that

Â assumes that at the beginning of the period that we're looking at,

Â whether it's a quarter or a year, that all the investors that had

Â convertible debt converted that into stock.

Â So in the numerator of EPS we're going to have to

Â adjust net income by the after tax interest expense on the convertible bond.

Â If the debt had converted to stock,

Â then there would have been no interest expense on the bond.

Â And so we need to add it back to net income and because net income is

Â an after tax number, we need to add back the after tax interest expense.

Â In the denominator of earnings per share, the number of shares is going to be

Â increased by the number of new shares that would be out there if the debt had been

Â converted to common shares at the beginning of the period.

Â 8:28

So let's take a look at an example.

Â For fiscal year 2013, Stack's net income of $25,000 included 500 of

Â interest expense on its convertible debt.

Â The debt is convertible into 2,000 shares of common stock.

Â So the holders of the debt could convert it to 2,000 shares.

Â We're going to assume that they did that at the beginning of the year.

Â The statutory tax rate is 35%.

Â So we're going to carry over basic EPS from before.

Â So this already has the net income minus preferred dividends in the numerator.

Â The weighted average common shares outstanding in the denominator.

Â Now we need to adjust that for the affective convertible debt,

Â converting to stock at the beginning of the year.

Â 9:11

So in the numerator we're going to add back the after tax interest expense.

Â So we add back 500 of interest expense time one minus the tax rate

Â to get the after tax portion.

Â And then in the denominator we start with our 24,000 and

Â then we add an extra 2,000 shares of common stock

Â assuming the convertible debt had converted on the first day of the year.

Â 9:57

>> We add back interest expense because the interest expense reduced net income.

Â So to remove it's effects, we need to add it back and since net income is after tax,

Â we add back after tax interest expense.

Â And we are taking a weighted average in the denominator.

Â Under the if converted method, the,

Â we assume that the convertible debt was converted on the first day of the year so

Â we actually have a full year of 2,000 shares.

Â It's not a fractional year so

Â we don't have to multiply it times a fraction, we get to record the whole year.

Â 10:48

>> Yeah I like that song too.

Â We're in the money, we're in the money.

Â We've got a lot of what it takes to get along.

Â But anyway, what it means in this case is an in-the-money stock option would

Â be one where the current stock price is above the exercise price.

Â Which means you would have incentive to exercise it because you'd make a profit.

Â And so those are the options that we're going to take into account for diluted EPS

Â because those are the ones that can turn into stock at any point in time.

Â So diluted EPS has to be computed under the assumption that some fraction of

Â these in-the-money options are converted to common shares.

Â The method we use is called the treasury stock method.

Â 11:29

In the numerator of EPS we don't need to make any adjustment.

Â And that's because stock options have no effect on

Â the income statement after they've been granted.

Â So these options were probably granted a long time ago.

Â There was an expense.

Â Now what's happened is the options are past the vesting period.

Â They're in the money.

Â Whether they're exercised or not has no impact on net income.

Â So we don't have to adjust anything in the numerator.

Â In the denominator, we need to add a number of

Â shares based on a fraction of each outstanding option.

Â And what we're going to do is figure out the number of additional shares as

Â the number of options times a conversion fraction.

Â And the conversion fraction is going to be the average stock price minus

Â the exercise price on the option all divided by the average stock price.

Â 12:16

>> Conversion fraction?

Â That is a real descriptive name.

Â Not.

Â Can you give me some intuition of what this fraction represents?

Â >> Yeah I agree.

Â Conversion fraction is not that descriptive, but

Â it's sort of a shortcut way to figure out how to do this method.

Â So the intuition is that the numerator, the average stock price minus

Â the exercise price is the profit that you would get from exercising the option.

Â So if the price was $40 and the exercise price was $10,

Â you could make a profit of $30 per option you exercised.

Â Now the assumption is you would take that $30 and

Â go buy shares of stock at the current stock price.

Â So how many shares could you buy for one option?

Â Well, you get $30 profit divided by the $40 stock price you could buy

Â three fourths of the share for one option.

Â So we take that three fourths times the number of options it would be

Â the number of shares that you could buy if you exercised.

Â Okay.

Â 13:14

Let's take a look at our example again.

Â During fiscal year 2013, Stack had 1,000 outstanding in

Â the money options with an average exercise price of ten.

Â Tthe average stock price during the period was 20, so we can see on average,

Â the stock options are $10 in the money.

Â If you held on these options, you could buy the stock from Stack at $10,

Â sell it on the open market for $20 and make $10 profit per share.

Â 13:40

Our conversion fraction is going to be 20 minus 10.

Â So the average prices minus the exercise price divided by 20 which is .5.

Â Once again the way to think about this is if I had one option,

Â I could exercise that option.

Â I would make $10 of profit, so that's the 20 minus 10.

Â Then I could take that $10 and buy half a share of stock at $20 per share.

Â And so these exercised options could turn into half a share,

Â each option turns into half a share.

Â 14:11

Here's the diluted EPS calculation that we carried over where we

Â did convertible debt, where we ended up with $0.78 per share.

Â Now what we're going to do is add nothing to the numerator.

Â Because again whether stock options are exercised or

Â not has no impact on the income statement.

Â In the denominator we're going to add 1,000 options

Â times the 0.5 conversion factor which means that we're going to add 500 shares.

Â So we're going to assume that if those 1,000 share, 1,000 options that were in

Â the money were exercised, the proceeds would be able to buy 500 shares.

Â So then when we divide the numerator and

Â denominator, we end up with a new diluted EPS of 77 cents per share.

Â 15:20

The big one is that diluted EPS must always be less than or equal to basic EPS.

Â It can never be greater than basic EPS when you finish all the calculations.

Â And to prevent that there's a number of things that we make sure we do.

Â First, diluted EPS is just set equal to basic EPS in years when

Â a firm has a loss from continuing operations to common shareholders.

Â The assumption here is that if a firm is losing money,

Â none of this convertible stuff's going to convert.

Â People are, investors are not eager to jump in and,

Â and acquire stock of a company that's losing money.

Â [LAUGH] And so the assumption here is we don't have to bother with the conversion

Â features, and we just set diluted EPS equal to basic EPS.

Â 15:59

If diluted EPS would be greater than basic EPS after convertible is

Â added to the calculation, the convertible is considered anti-dilutive and

Â excluded from the computation.

Â So sometimes depending on the conversion details and

Â the interest rate, you could actually have the effect of the interest expense

Â dominate the effect of the extra shares and actually have diluted EPS go up.

Â So to prevent that from happening, we would just ignore that convertible debt

Â if it was anti-dilutive, if it would cause diluted EPS to raise above basic EPS.

Â And then stock options are always considered anti-dilutive.

Â In other words ignored when the exercise prices is greater than the market prices.

Â So when the option is out of the money.

Â So, that makes sense because if the exercise price is

Â greater than the market price nobody would ever exercise it you would be,

Â you would buy the stock cheaper at the market price.

Â You would never exercise the option.

Â So because of these features, you will always see that diluted EPS is

Â either equal to basic, or it's less than basic EPS.

Â 17:09

>> Who cares?

Â Well shareholders certainly care, as do potential investors,

Â because when you own a company and you're trying to use this earnings per share

Â measure to figure out how much of these earnings are attributable to my shares of

Â stock, one thing you worry about is that there can all of a sudden be new shares of

Â stock out there, and if these new shares of stock appear due to convertible debt or

Â stock options, how would that cut into the piece of the earnings that goes to you?

Â So diluted EPS gives you that worse case scenario assuming everything that

Â could convert converts.

Â And see, let's you see how much your earnings would be

Â eroded by these additional claims.

Â This diluted EPS number then becomes the big number that people use when

Â assessing performance, when comparing two price for

Â the PE multiple, when comparing the dividends for share.

Â So it is one of the big performance measures out there and

Â that's why there's a requirement that it's reported and

Â why we went through all this detail to learn it.

Â 18:10

And with that, we have learned all the new material that

Â we're going to learn on stockholder's equity.

Â In the next video we're going to take a look at some disclosures to see how to

Â pick this information out of the footnotes and the statements.

Â I'll see you then.

Â