Hello, I'm Professor Brian Bushee and welcome back. In this video, we're going to talk about earnings per share. Seems like it should be an easy video to do. Take earnings, divide by shares, you're done. Except that there are a lot of complications in this calculation, as you'll see. Let's get started. Earning per share, or EPS, provides a measure of how much earnings was generated for each share of common stock held by outsiders. So the idea is to take this performance measure earnings and scale it by the number of shares outstanding, so that each share holder can say how much earnings did the company generate for me this period versus the number of shares that I hold. It's extremely common number in finance reporting. So the company often emphasizes this number at the earnings announcement, and then the media often picks up what the EPS was for the companies fiscal period. It's the number that's forecasted by security analysts. And it's compared to price per share to get this thing called the price-earnings ratio or P/E ratio, which is a quick and dirty evaluation technique that investors use where they have some notion of what the multiple that price should be over earnings. So when you get this EPS number, you multiply it times the multiple and it gives you what the price should be. We're going to start with basic EPS, basic earnings per share which is defined as net income minus preferred dividends. So we take out preferred dividends to try to get some notion of the return for common shareholders. And we divide it up by the weighted average number of common shares outstanding. >> I do declare. Why do y'all subtract preferred dividends? What do y'all mean by a weighted average? It is not polite to discuss people's weight. I assume the same would be true of shares. >> No, no. It's okay to talk about weight with shares. So weighted average means that we weigh the average by how long the shares were outstanding. So if we had 10,000 shares outstanding for three quarters of a year, 15,000 shares for one quarter of the year, we would take three fourths of 10,000 plus one fourth of 15,000 to get the weighted average. And we subtract preferred dividends because we're looking at this notion of how much is left for common share holders, so net income already takes out interest expense which are the distributions to bond holders. In addition, we take out the preferred dividends, which don't show up in the income statement, to get this notion of what is leftover for the common stock holders. Let's take a look at an example. So for the year ended December 31 2013, Stack reported net income of $25,000. On January 1st, 2013, Stack had 22,000 common shares outstanding, and 10,000 preferred shares outstanding. So that was what they had at the beginning of 2013. Stack issued 4,000 new common shares on June 20th, 2013. So they issued more shares in the middle of the year. During the year Stack paid 5,000 preferred dividends, and 9,000 of common dividends. So we're going to try to figure out Stack Incorporated's basic EPS. So, we can start filling in what we know. So net income is $25,000. We subtract 5,000 of preferred dividends. We ignore the common dividends. We don't need them for this calculation. Then for the denominator we're looking at for weighted average number of common shares outstanding. So first off, we ignore preferred shares. When we look at the common shares, they had 22,000 shares at the beginning of the year and those are outstanding throughout the year. But then they added 4,000 shares for half a year. So to get the weighted average we take 22,000 shares for the full year, plus they had four thousand shares for half a year. We have 24,000 shares in the denominator and of course we have 20,000 in the numerator of net income minus preferred dividends. Another way that you could try to calculate this denominator would be to think of it as you had 22,000 shares outstanding for half the year from January through the end of June. And then you had 26,000 shares outstanding for half the year from July 1 to December 31. And so if you take half a year at 22,000, half a year at 26,000 you end up with the same 24,000 in the denominator. And so that's going to give us a basic earnings per share of $.83. >> Okay. So is 83 cents a good or a bad EPS number? It seems pretty low to me. You'd think in this day and age, a company could least give you a dollar of EPS. >> I'm not sure the right way to look at earnings per share is in an absolute sense, like over a dollar a share is good, or over a dollar a share is bad. You really want to compare this to other per-share numbers for the company, like prior years' earnings per share, dividends per share, or maybe the most common use is price per share to get this price earnings multiple. So don't think of earnings per share as there's an absolute benchmark. But usually you're trying to meet last year's earning per share or analyst forecast for earnings per share. And then you're really concerned about this ratio of price per share to earnings per share. Hopefully it's high and high within your industry. So now we're going to talk about diluted EPS. So companies with complex capital structures also have to report something called diluted EPS. As it turns out, almost every company has one of these instruments. So almost every company reports diluted EPS. And it turns out that diluted EPS is the number that most people focus on rather than basic EPS. So what does a complex capital structure mean? It means that there's securities that can be converted into shares of common stock at the investor's discretion. So this would include things like convertible debt. So an investor holds debt, but they have the option to convert that into shares of stock. Or stock options and warrants. Warrant is another form of stock option, but this gives the holder of the option or the warrant the ability to convert that into new shares of stock. Now, some of the value of these convertible securities is tied to the value of the common stock. You know, basically you, you get a stock option or you get convertible debt and part of the price of getting that incorporates the price of the common stock because there's this option to convert. So in a sense, the investors holding these securities are like indirect stockholders. And we really should count them as at least some fraction of the common shareholders at the time we do the EPS calculation. So what diluted EPS is going to do is give you an EPS number assuming that everything that could convert to a share of stock actually did convert to a share of stock. So the definition's going to be take net income minus preferred dividends, but then add an adjustment for convertibles, what would happen if they converted to common stock. And then in the denominator, we'll take the weighted average common shares outstanding, and again adjust for the effect of these convertibles. Assuming that everything could convert would actually do so. And first we're going to look at the effect of convertible debt on diluted EPS. So as I mentioned, convertible debt can be exchanged for common stock at the holder's option. Diluted EPS is computed under the assumption that that convertible debt was exchanged for common stock at the beginning of the period. This is called the if converted method, so we'll see an EPS number that assumes that at the beginning of the period that we're looking at, whether it's a quarter or a year, that all the investors that had convertible debt converted that into stock. So in the numerator of EPS we're going to have to adjust net income by the after tax interest expense on the convertible bond. If the debt had converted to stock, then there would have been no interest expense on the bond. And so we need to add it back to net income and because net income is an after tax number, we need to add back the after tax interest expense. In the denominator of earnings per share, the number of shares is going to be increased by the number of new shares that would be out there if the debt had been converted to common shares at the beginning of the period. So let's take a look at an example. For fiscal year 2013, Stack's net income of $25,000 included 500 of interest expense on its convertible debt. The debt is convertible into 2,000 shares of common stock. So the holders of the debt could convert it to 2,000 shares. We're going to assume that they did that at the beginning of the year. The statutory tax rate is 35%. So we're going to carry over basic EPS from before. So this already has the net income minus preferred dividends in the numerator. The weighted average common shares outstanding in the denominator. Now we need to adjust that for the affective convertible debt, converting to stock at the beginning of the year. So in the numerator we're going to add back the after tax interest expense. So we add back 500 of interest expense time one minus the tax rate to get the after tax portion. And then in the denominator we start with our 24,000 and then we add an extra 2,000 shares of common stock assuming the convertible debt had converted on the first day of the year. So that gives us 20,325 divided by 26,000, or $0.78 per share of diluted EPS. >> Oh darling! Why do y'all add the interest expense to Net Income instead of subtracting it? And why did y'all not take a weighted average in the denominator? >> We add back interest expense because the interest expense reduced net income. So to remove it's effects, we need to add it back and since net income is after tax, we add back after tax interest expense. And we are taking a weighted average in the denominator. Under the if converted method, the, we assume that the convertible debt was converted on the first day of the year so we actually have a full year of 2,000 shares. It's not a fractional year so we don't have to multiply it times a fraction, we get to record the whole year. Now let's take a look at how stock options would affect diluted EPS. So in-the-money stock options give the holder the right to acquire a share of common stock at a pre-specified price. >> I love the song We're in the Money. But what in tarnation does it have to do with stock options? >> Yeah I like that song too. We're in the money, we're in the money. We've got a lot of what it takes to get along. But anyway, what it means in this case is an in-the-money stock option would be one where the current stock price is above the exercise price. Which means you would have incentive to exercise it because you'd make a profit. And so those are the options that we're going to take into account for diluted EPS because those are the ones that can turn into stock at any point in time. So diluted EPS has to be computed under the assumption that some fraction of these in-the-money options are converted to common shares. The method we use is called the treasury stock method. In the numerator of EPS we don't need to make any adjustment. And that's because stock options have no effect on the income statement after they've been granted. So these options were probably granted a long time ago. There was an expense. Now what's happened is the options are past the vesting period. They're in the money. Whether they're exercised or not has no impact on net income. So we don't have to adjust anything in the numerator. In the denominator, we need to add a number of shares based on a fraction of each outstanding option. And what we're going to do is figure out the number of additional shares as the number of options times a conversion fraction. And the conversion fraction is going to be the average stock price minus the exercise price on the option all divided by the average stock price. >> Conversion fraction? That is a real descriptive name. Not. Can you give me some intuition of what this fraction represents? >> Yeah I agree. Conversion fraction is not that descriptive, but it's sort of a shortcut way to figure out how to do this method. So the intuition is that the numerator, the average stock price minus the exercise price is the profit that you would get from exercising the option. So if the price was $40 and the exercise price was $10, you could make a profit of $30 per option you exercised. Now the assumption is you would take that $30 and go buy shares of stock at the current stock price. So how many shares could you buy for one option? Well, you get $30 profit divided by the $40 stock price you could buy three fourths of the share for one option. So we take that three fourths times the number of options it would be the number of shares that you could buy if you exercised. Okay. Let's take a look at our example again. During fiscal year 2013, Stack had 1,000 outstanding in the money options with an average exercise price of ten. Tthe average stock price during the period was 20, so we can see on average, the stock options are $10 in the money. If you held on these options, you could buy the stock from Stack at $10, sell it on the open market for $20 and make $10 profit per share. Our conversion fraction is going to be 20 minus 10. So the average prices minus the exercise price divided by 20 which is .5. Once again the way to think about this is if I had one option, I could exercise that option. I would make $10 of profit, so that's the 20 minus 10. Then I could take that $10 and buy half a share of stock at $20 per share. And so these exercised options could turn into half a share, each option turns into half a share. Here's the diluted EPS calculation that we carried over where we did convertible debt, where we ended up with $0.78 per share. Now what we're going to do is add nothing to the numerator. Because again whether stock options are exercised or not has no impact on the income statement. In the denominator we're going to add 1,000 options times the 0.5 conversion factor which means that we're going to add 500 shares. So we're going to assume that if those 1,000 share, 1,000 options that were in the money were exercised, the proceeds would be able to buy 500 shares. So then when we divide the numerator and denominator, we end up with a new diluted EPS of 77 cents per share. >> I noticed that diluted EPS keeps getting smaller the more items we add. Can it ever get bigger? >> No. Diluted EPS can never get bigger than basic EPS. It's always going to be smaller, or equal to. And the reasons why, we'll talk about in the next slide. So there are a couple complications that you have to keep in mind when calculating diluted EPS. The big one is that diluted EPS must always be less than or equal to basic EPS. It can never be greater than basic EPS when you finish all the calculations. And to prevent that there's a number of things that we make sure we do. First, diluted EPS is just set equal to basic EPS in years when a firm has a loss from continuing operations to common shareholders. The assumption here is that if a firm is losing money, none of this convertible stuff's going to convert. People are, investors are not eager to jump in and, and acquire stock of a company that's losing money. [LAUGH] And so the assumption here is we don't have to bother with the conversion features, and we just set diluted EPS equal to basic EPS. If diluted EPS would be greater than basic EPS after convertible is added to the calculation, the convertible is considered anti-dilutive and excluded from the computation. So sometimes depending on the conversion details and the interest rate, you could actually have the effect of the interest expense dominate the effect of the extra shares and actually have diluted EPS go up. So to prevent that from happening, we would just ignore that convertible debt if it was anti-dilutive, if it would cause diluted EPS to raise above basic EPS. And then stock options are always considered anti-dilutive. In other words ignored when the exercise prices is greater than the market prices. So when the option is out of the money. So, that makes sense because if the exercise price is greater than the market price nobody would ever exercise it you would be, you would buy the stock cheaper at the market price. You would never exercise the option. So because of these features, you will always see that diluted EPS is either equal to basic, or it's less than basic EPS. >> I just have one more question. Who cares? >> Who cares? Well shareholders certainly care, as do potential investors, because when you own a company and you're trying to use this earnings per share measure to figure out how much of these earnings are attributable to my shares of stock, one thing you worry about is that there can all of a sudden be new shares of stock out there, and if these new shares of stock appear due to convertible debt or stock options, how would that cut into the piece of the earnings that goes to you? So diluted EPS gives you that worse case scenario assuming everything that could convert converts. And see, let's you see how much your earnings would be eroded by these additional claims. This diluted EPS number then becomes the big number that people use when assessing performance, when comparing two price for the PE multiple, when comparing the dividends for share. So it is one of the big performance measures out there and that's why there's a requirement that it's reported and why we went through all this detail to learn it. And with that, we have learned all the new material that we're going to learn on stockholder's equity. In the next video we're going to take a look at some disclosures to see how to pick this information out of the footnotes and the statements. I'll see you then. >> See you next video!