Slide 27.1 Earnings Per Share Chapter 27. Slide 27.2 By the end of the chapter, you should be able...

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Earnings Per Share

Chapter 27

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By the end of the chapter, you should be able to:

• define earnings per share and the PE ratio;

• comment critically on the PE ratio of an enterprise in comparison with the industry average;

• calculate the basic and diluted earnings per share.

Objectives

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Investor Ratios

Investor ratios The market price and performance of a company’s

shares indicate what investors think of a company. Market price:

the price people are willing to buy and sell the shares of a company for.

Includes information about how investors see the potential risk and return connected with owning a part of the company.

Companies are diverse: they have different numbers of issued shares, differing levels of profits and dividends, differing activities/industries and differing future prospects.

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Investor Ratios

To get the necessary information to enable an investment decision to be made, the following ratios need to be considered: earnings per share price/earnings ratio dividend per share dividend yield dividend cover net tangible asset backing per share.

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Investor Ratios

Price/earnings (P/E) ratio Measures the ratio of the current market price of the ordinary

shares to the EPS of the ordinary shares. Useful for comparing different companies.

Tells how many years the investor is prepared to wait to recover the price of the shares at the current rate of return

If a company’s P/E ratio is higher than that of other companies, investors expect its profits (and dividends and share price) to grow more quickly than those of the other companies.

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Investor Ratios

Dividends per share (DPS) Shows how much of the net profit is paid to shareholders

for each ordinary share they hold. Normally, DPS will be less than EPS because companies

prefer to retain part of the net profit to help fund future expansion. The formula is:

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Investor Ratios

Dividend yield The ratio of DPS to the share’s market price. It measures

the percentage of the share’s value that is returned each year as dividends to the shareholder. Preference shareholders, whose main reason for investing is to receive dividends, pay special attention to this ratio. The formula is:

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Investor Ratios

Dividend cover Shows how many times the net profit after tax and

preference dividends covers the dividend payout to ordinary shareholders. The ratio is calculated as follows:

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Investor Ratios

Net tangible asset backing per share (NTA) Also called the book value per share. Shows how much the shareholder can expect to get back

should the company cease operations. It assumes that the value of the assets shown in the

Balance Sheet is a fair indication of the price that would be obtained if they were sold. The formula is:

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Earnings per share

• Why EPS is important

• IAS 33 calculation of Basic EPS

• BEPS after bonus issue, share split, new issue, buyback of shares and rights issue

• Calculate diluted EPS

• Treatment where there are several potential dilutions.

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Why EPS is important

Component of PE ratio Typical press extract.

EPS

35.95 8.65 57.40

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Factors that affect the PE ratio

Investors’ confidence – external influences International scene National economy Industry sector.

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Factors that affect the PE ratio (Continued)

Investors’ confidence – external influencesCurrent year’s performance

Potential changes and possible future implication Management change

• replacing failing• recruiting successful

High growth prospects – high PE ratio Poor growth prospects – high PE if takeover likely.

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Investor Ratios

Earnings per share (EPS) EPS is the amount of net profit per share of the company’s

ordinary shares. The formula is

The net profit available for paying dividends to the ordinary shareholders is used.

Preference dividends and taxes are deducted because the preference shareholders and the Inland Revenue Department have prior claims on the profit.

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Earnings per share – basic calculation

Basic EPS = earnings/weighted number of ordinary shares

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Earnings per share – diluted calculation

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Investor Ratios

Calculating the number of shares on issue can be difficult to determine – why?

Effect of convertible securities on issue, share options on issue, warrants on issue, and accounting polices

Why do these create a problem? Must allow for the likely number of shares that will be

taken up by holders of these securities at the option date.

Accounting policies can affect the calculation of EPS because of the effect a change in accounting policies can have on the net profit figure.

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Limitations of EPS as performance measure

Based on historical earningsNo account of inflation

Real growth differing from apparent growthInter-company comparison adversely affected

Management choice over accounting policies Changes in capital structure.

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BEPS calculation

Watts plc share capital 1m 50p ordinary shares 1m £1 10% preference shares

Watts post tax profit for 20X1 £1,250,000.

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BEPS calculation – bonus issue

Assume post-tax profit in 20X0 and 20X1 £1,250,000

Assume bonus issue increased number of shares from 1m 50p to 2m 50p

In 20X1 BEPS halved from £1.15 to £0.575

20X0 BEPS restated from £1.15 to £0.575.

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BEPS calculation – share splits

Treated same way as a bonus issue

Affects both current and previous year

Aim is to avoid appearance of a fall compared to previous year.

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BEPS calculation – new issue Now assume Company issues 500,000 new shares on 1

September 20X1.

Company does not have use for new capital for full year

Misleading to use the closing number of shares

Weight the number on a time-held basis.

£

No. of shares

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BEPS calculation – buyback atmarket value Aim is to include the number of shares on a time-held

basis

Weigh from beginning of year until date of buyback. Assume Watts bought back 240,000 on 31.5.20X1.

£ £

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BEPS – rights issue

Four-step approach.

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Rights issue calculation

Assume 50p ordinary shares had £4 market value

Assume company offered a rights issue of One 50p share @ £3.25

For every two 50p shares held.

£

£

£

£

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Rights issue calculation (Continued)

Bonus element.

2 shares at fair value of £4 each prior to rights issue1 share at discounted rights issue price of £3.25 each3 shares at fair value after issue (i.e. ex-rights)The theoretical ex-rights price is 11.25/3 sharesThe bonus element is fair value 4 less 3.75

£

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Time apportion number of shares if issued part way through the year

If 500,000 shares issued after 3 months then weighted number is 125,000.

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Further adjustment to recognise bonus element.

£

£

£

£

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Adjusted number of shares for current year.

No. of shares

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Adjust previous year for bonus element.

£

£

£

£

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Diluted EPS

Dilution may arise from:

Convertible bonds

Convertible preference shares

Share options

Share warrants.

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Diluted EPS – share options

£

£

£

£A

P

S

A

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Diluted EPS – convertible bonds

A

I

A

A

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Diluted EPS – convertible preference shares

Assume that Watts had at 31.12.20X1.

£

£

£

A

P

C

C

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£

£

£

Diluted EPS – convertible preference shares (Continued)

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Diluted EPS – several potential dilutions

Assume that Watts had at 31.12.20X1.

£

£

£

£

£

£ £

P

S

A

A

C

C

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Diluted EPS – several potential dilutions (Continued)

Increase inearnings

Increase in number of ordinary shares

Earnings perincremental share

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Diluted EPS – several potential dilutions (Continued)

Step 2: Determine the potential ordinary shares to includein the computation of diluted earnings per share

Net profitattributable to

continuing operations

Ordinaryshares

Per share

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Discussion questions

Explain the limitation of EPS as a performance measure

Explain why a rights issue requires an adjustment with EPS of previous year

Explain what you understand by anti-dilutive.

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Review questions

1. Explain:

(i) Basic earnings per share

(ii) Fully diluted earnings per share

(iii) Potential ordinary shares and

(iv) Limitation of EPS as a performance measure

2. Why are issues at full market value treated differently from rights issues?

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Review questions (Continued)

6. Income smoothing describes the management practice of maintaining a steady profit figure

(a) Explain why managers might wish to smooth the earnings figure. Give three examples of how they might achieve this

(b) It has been suggested that debt creditors are most at risk from income smoothing by the managers. Discuss why this should be so

7. In connection with IAS 33 Earnings per Share:

(a) Define the profit used to calculate basic and diluted EPS

(b) Explain the relationship between EPS and the price/earnings (P/E) ratio. Why may the P/E ratio be considered important as a stock market indicator?

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