EARNINGS PER SHARE (EPS)

NOTE:
Under IAS, only parent company is required to present EPS on the basis of consolidated information, at the bottom on the face of the Income Statement. An entity who has neither ordinary shares nor potential ordinary shares which are publicly traded should calculate and present EPS.

Earnings per share (EPS) shows the trend of earnings performance for a company over years. EPS is an input ratios such as the price/ earnings ratio. It is not useful in comparing company. SCOPE: Under IFRS, IAS No. 33, Earning Per Share, should be applied by entities; whose ordinary shares or potential ordinary shares are publicly traded that are in process of issuing ordinary shares (or potential ordinary shares) in public securities markets. A companys capital is composed of its equity and debt. Some types of equity have preferences over others, and some debt may be converted into equity. Under IFRS, the type of equity for which EPS is presented are ordinary shares.

________________________________________________________________________________________________________ 1. DEFINITIONS: Ordinary Shares are those equity shares that are subordinate to all other types of equity. NOTE: This is the basic ownership of the company the equity holders who are paid last in a liquidation of the company and who benefit the most when the company does well. A Potential Ordinary Shares is a financial instrument or other contract that may entitle its holder to ordinary shares. Examples includes; Convertible instruments Share Options and warrants Share Purchase Plans and Shares which will be issued subject to certain conditions being met. Warrants or Options are financial instruments that give the holder the right to purchase ordinary shares. When a company/ entity has any securities that are potentially convertible into ordinary share, it is said to have a Complex Capital Structure. Specific example includes convertible preferred share, convertible bonds, employee stock options and warrants etc. If a companys capital structure does not include securities that are potentially convertible into ordinary shares, it is said to have a Simple Capital Structure.

2. BASIC EPS: Basic EPS is the amount of income statement available to ordinary shareholders divided by the weighted average number of common shares outstanding over a period. The amount of income available to ordinary shareholders is the amount of net income remaining after preferred dividends (if any) have been paid. Thus, the formula to calculate basic EPS is; Basic EPS = Net income Preferred dividends Weighted average number of shares outstanding (WANSO) The weighted average number of shares outstanding (WANSO) is a time weighting of ordinary shares outstanding, and the methodology applies to calculating diluted EPS.

If the number of shares of ordinary shares increases as result of a stock dividend, stock bonus or a stock split (all three represent the receipt of additional shares by existing shareholders), the EPS calculation reflects the change retroactively to the beginning of the period. EXAMPLE 1: For the year ended 31 December 2010, Haider Company had net income of PKR 1,950,000. The company had an average of 1,500,000 ordinary shares outstanding, no potential ordinary shares. What was Haider Companys basic EPS? Solution: Haider Companys basic EPS was PKR 1.30, calculated as; = 1,950,000 / 1,500,000 => 1.30 Issues of shares where no cash is consideration: The weighted average number of shares during the period and for all the periods presented should be adjusted for events, that have changed the ordinary number of shares outstanding; Bonus issues, bonus elements in another issue (e.g. right issue), stock splits and reverse stock splits If the number of shares of ordinary shares increases as result of a stock dividend, stock bonus or a stock split (all three represent the receipt of additional shares by existing shareholders), the EPS calculation reflects the change retroactively to the beginning of the period. The EPS will fall because the earnings are being spread over a larger number of shares. EXAMPLE 2: For the year ended 31st December 2010, Lasania Products had net income of PKR 2,500,000. The Company declared and paid PKR 200,000 of dividends on preferred shares. The company also had the following potential ordinary shares information: Shares outstanding on 1 January 2010 1,000,000 Shares issued on 1 April 2010 200,000 Shares repurchased (treasury shares) on 1 October 2010 (100,000) Shares outstanding on 31st December 2010 1,100,000 1. What is the companys weighted average number of shares outstanding (WANSO)? 2. What is the companys basic EPS? Solution 1: The weighted average number of shares outstanding (WANSO) is determined by the length of time each quantity of shares was outstanding: 1,000,000 x (3 months/12 months) = 250,000 1,200,000 x (6 months/12 months) = 600,000 1,100,000 x (3 months/12 months) = 275,000 Weighted average number of shares outstanding (WANSO) 1,125,000 Solution 2: Basic EPS is (Net income Preferred dividends)/ Weighted average number of shares outstanding (WANSO) = (2,500,000 200,000)/ 1,125,000 = PKR 2.04 EXAMPLE 3: Assume the same fact as in Example 2 except that on 1 December 2010, the Company institutes a 2 for 1 stock split. What is the companys EPS Solution: For EPS calculation purposes, a stock split is treated as if it occurred at the beginning of the period. The weighted average number of shares would be, therefore, be 2,250,000 and the basic EPS would be PKR 1.02.

Practice Question 1:

For 2009, JPV Services Ltd had net income of PKR 1,000,000. At 1 January 2009, there were 100,000 shares outstanding. On 1 July 2009, the company issued 100,000 new shares for PKR 20 each. The company paid 200,000 in dividends to ordinary shareholders. What is JPVs basic EPS for 2009?

1.

DILUTED EPS:

The distinction between simple versus complex capital structure is relevant to the calculation of EPS because any securities that are potentially convertible into ordinary shares could, as a result of conversion, potentially dilute (i.e. decreases EPS). Information about such a potential dilution is valuable to a companys current and potential shareholders, therefore, accounting standards require companies to disclose what their EPS would be if all dilutive securities were converted into ordinary shares. The EPS that would result if all dilutive securities were converted is called diluted EPS. In contrast, basic EPS is calculated using the actual earnings available to ordinary shares and the weighted average number of shares outstanding (WANSO). Companies are required to report both their basic EPS and their diluted EPS. DILUTED EPS: CONVERTIBLE PREFERRED SHARES OUTSTANDING When a company has convertible preferred shares outstanding, diluted EPS is calculated using the if-converted method (i.e., what EPS would have been if the convertible preferred securities had been converted at the beginning of the period). If the convertible preferred securities had been converted, these securities would no longer be outstanding; instead, additional ordinary shares would be outstanding. Therefore, if such a conversion had been taken place, The company would not have been paid preferred dividends and would have more shares of ordinary shares. Thus, the formula to calculate diluted EPS using the if-converted method for preferred stock is; Diluted EPS = Net income (WANSO + New ordinary shares that would have been issued at conversion) EXAMPLE 4: For the year ended 31 December 2009, Al-Karim Utility Company had net income of PKR 1,750,000. The company had an weighted average number of shares outstanding 500,000, 20,000 shares of convertible preferred, and no other potentially ordinary shares. Each share of preferred pays a dividend of PKR 10 per share and each is convertible into five (05) shares of the companys ordinary shares. Calculate the companys basic and diluted EPS. Solution: Basic EPS Diluted EPS = Net income preferred dividends = 1,750,000 200,000 = PKR 3.10 WANSO 500,000 = Net income WANSO+ new shares due to conversion = 1,750,000 = PKR 2.92 500,000

DILUTED EPS: CONVERTIBLE DEBT OUTSTANDING When a company has convertible debt outstanding, diluted EPS is calculated using the if-converted method (i.e., what EPS would have been if the convertible debt securities had been converted at the beginning of the period). To calculate diluted EPS using the if-converted method for convertible debt, the amount of net income available to ordinary shareholders must be increased by the amount of after-tax interest related to the convertible debt. In addition, the weighted average number of shares outstanding (WANSO) in the denominator increases by the number of new shares of ordinary shares that would be issued upon conversion of the convertible debt. Thus, the formula to calculate diluted EPS using the if-converted method for convertible debt is; Diluted EPS = Net income + After-tax interest on convertible debt Preferred dividends if only convertible (WANSO + New ordinary shares that would have been issued at conversion) debt

Diluted EPS = Net income + After-tax interest on convertible debt Preferred dividends (WANSO + New ordinary shares that would have been issued at conversion)

(if both)

EXAMPLE 5: Omar Company reported net income of PKR 750,000 for the year ended 31 December 2009. The company had an average of 690,000 shares of ordinary shares outstanding. In addition, the company has only one potentially ordinary share: PKR 50,000 of 6% convertible debt, convertible into a total of 10,000 shares. Assuming a tax rate of 30%. Calculate basic and diluted EPS. Solution: Basic EPS Diluted EPS 1.07 = Net income preferred dividends = 750,000 0 = PKR 1.09 WANSO 690,000 = Net income + After-tax interest on convertible debt* WANSO+ new shares due to conversion = 750,000 + 2,100 = PKR 690,000 +10,000

* After-tax interest on convertible debt = 50,000 x 6% = 3,000 TAX (30% of 3,000 i.e. 9,000) = 2,100 PRACTICE QUESTION: (ICMAP SUMMER 2010, Q 4, PART B) Moon Limited has ordinary share capital of PKR 15 million consisting of shares of PKR 10 each. Additional financing was provided by following loans: (i) PKR 2 million 15% loan that could be converted into ordinary shares in three years time at the rate of one share per PKR 20 of loan. (ii) PKR 3 million 12% loan that could be converted into ordinary shares in one years time at the rate of one share per PKR 15 of loan. Earnings for the year are PKR 2.5 million and applicable income tax rate is 35%. Required: Compute basic EPS and diluted EPS. SOLUTION: Number of shares outstanding: Potentially convertible debt (i): After-tax interest on convertible debt Potentially convertible debt (ii): After-tax interest on convertible debt Net income Calculate Basic and Diluted EPS; Hint: separated convertible debt be solved. DILUTED EPS: STOCK OPTIONS, WARRANTS OR THEIR EQUIVALENT OUTSTANDING When a company has Stock options, warrants or their equivalent outstanding, diluted EPS is calculated using the if-converted method (i.e., what EPS would have been if the options had been exercised and the company had used the proceeds to repurchase ordinary shares). To calculate diluted EPS for options, the weighted average number of shares (WANSO) in the denominator increases by the number of new shares of ordinary shares that would be issued upon exercise of the options minus the number of shares that could have been purchased with the cash received upon exercise of the options. No change is made to the numerator. Thus, the formula to calculate diluted EPS for options is; Diluted EPS = Net income Preferred dividends (WANSO + New shares* shares that could have been purchased with cash received upon exercise PKR 15 million/ PKR 10 each = 1.5 million shares PKR 2 million (three years) 2 million x 15% = PKR 300,000 TAX = 300,000 (300,000 x 35%) = 300,000 105,000 = PKR 195,000 PKR 3 million (one year) 3 million x 12% = PKR 360,000 TAX = 360,000 (360,000 x 35%) = 360,000 126,000 = PKR 234,000 PKR 2.5 million

* that could have been issued at option exercise EXAMPLE 6: Jabbar Company reported net income of PKR 2.3 million for the year ended 30 June 2008 and had an average of 800,000 ordinary shares outstanding. The Company has outstanding 30,000 options with an exercise price of PKR 35 and no other potentially dilutive securities. Over the year, the Companys market price has average PKR 55 per share. Calculate the basic and dilutive EPS. Solution: Basic EPS = Net income preferred dividends WANSO = 2,300,000 0 800,000 = PKR 2.88

Diluted EPS = Net income preferred dividends WANSO + New shares - shares that could have been purchased with cash received upon exercise = 2,300,000 0 = PKR 2.84 800,000+10,909* (30,000 19,091) *New shares that could have issued at option exercise: 30,000 options Amount received if exercised @ PKR 35 each = PKR 1,050,000 Shares that could have been purchased with cash received upon exercise @ PKR 55 each = 1,050,000/55 = 19,091 2. OTHER ISSUES WITH DILUTIVE EPS: It is possible that some potentially ordinary shares could be antidilutive (i.e., their inclusion in the computation would result in an EPS higher than the companys basic EPS). Under accounting standards i.e. IFRS/ IAS, antidilutive securities are not included in the calculation of diluted EPS. In general, diluted EPS reflects maximum potential dilution. EXAMPLE 7: For the year ended 31 December 2008, Abbasi Utility Company Ltd had net income of PKR 1,750,000. The company had an average of 500,000 shares of convertible preferred, and no other potentially ordinary shares. Each share of preferred pays a dividend of PKR 10 per share and each is convertible into three (03) shares of the companys ordinary shares. What is the companys basic and diluted EPS? Solution: Basic EPS = 1,750,000 200,000 500,000 = PKR 3.10

Diluted EPS = 1,750,000 0 = PKR 3.13* 500,000 + 60,000 * Exceeds basic EPS, security is antidilutive and therefore, not included