IFRS require the presentation of EPS on the face of the income statement for net profit or loss (net income) and profit or loss (income) from continuing operations and similar presentation is required under US GAAP.
Simple versus Complex Capital Structure
Ordinary shares are those equity shares that are subordinate to all other types of equity.
The ordinary shareholders are basically the owners of the company — the equity holder who are paid last in a liquidation of the company and who benefit the most when the company does well.
Under US GAAP, the ordinary equity is referred to as common stock or common shares.
When a company has issued any financial instruments that are potentially convertible into common stock, it is said to have a complex capital structure.
The EPS that would result if all dilutive financial instruments were converted is called diluted EPS.
Basic EPS is calculated using the reported earnings variable to common shareholders of the parent company and the weighted average number of shares outstanding.
Companies are required to report both basic and diluted EPS as well as amounts for continuing operations.
Basic EPS
Basic EPS is the amount of income available to common shareholders divided by the weighted average number of common shares outstanding over a period.
The weighted average number of shares outstanding is a time-weighting of common shares outstanding.
Diluted EPS: The If-Converted Method
If a company has a simple capital structure (in other words, one that includes no potentially dilutive financial instruments), then its basic EPS is equal to its diluted EPS.
A company has potentially dilutive financial instruments, its diluted EPS may differ from its basic EPS.
Diluted EPS is always equal to or less than basic EPS.
The effects of three types of potentially dilutive financial instruments on diluted EPS:
- convertible preferred,
- convertible debt,
- and employee stock options.
Diluted EPS When a Company Has Convertible Preferred Stock Outstanding
When a company has convertible preferred stock outstanding, diluted EPS is calculated using the if-converted method.
If the convertible shares had been converted, there would be two effects.
- First, the convertible preferred securities would no longer be outstanding; instead, additional common stock would be outstanding. Thus, under the if-converted method, the weighted average number of shares outstanding would be higher than in the basic EPS calculation.
- Second, if such a conversion had taken place, the company would not have paid preferred dividends. Thus, under the if-converted method, the net income available to common shareholders would be higher than in the basic EPS calculation.
Diluted EPS using the if-converted method for convertible preferred stock is equal to net income divided by the weighted average number of shares outstanding from the basic EPS calculation plus the additional shares of common stock that would be issued upon conversion of the preferred.
Diluted EPS When a Company has Convertible Debt Outstanding
When a company has convertible debt outstanding, the diluted EPS calculation also uses the if-converted method.
Diluted EPS is calculated as if the convertible debt had been converted at the beginning of the period. If the convertible debt had been converted, the debt securities would no longer be outstanding; instead, additional shares of common stock would be outstanding. Also, if such a conversion had taken place, the company would not have paid interest on the convertible debt, so the net income available to common shareholders would increase by the after-tax amount of interest expense on the debt converted.
Diluted EPS: The Treasury Stock Method
When a company has stock options, warrants, or their equivalents outstanding, diluted EPS is calculated as if the financial instruments had been exercised and the company had used the proceeds from exercise to repurchase as many shares of common stock as possible at the average market price of common stock during the period. The weighted average number of shares outstanding for diluted EPS is thus increased by the number of shares that would be issued upon exercise minus the number of shares that would have been purchased with the proceeds.
For the calculation of diluted EPS using this method, the assumed exercise of these financial instruments would have the following effects:
- The company is assumed to receive cash upon exercise and, in exchange, to issue shares.
- The company is assumed to use the cash proceeds to repurchase shares at the weighted average market price during the period.
Other Issues with Diluted EPS and Changes in EPS
It is possible that some potentially convertible securities could be antidilutive (i.e., their inclusion in the computation would result in an EPS higher than the company’s basic EPS). Under IFRS and US GAAP, antidilutive securities are not included in the calculation of diluted EPS. Diluted EPS should reflect the maximum potential dilution from conversion or exercise of potentially dilutive financial instruments. Diluted EPS will always be less than or equal to basic EPS.
Changes in EPS
Changes in the numerator and denominator explain the changes in EPS arithmetically. To understand the business drivers of those changes requires further research. Lesson 5 presents analytical tools that an analyst can use to highlight areas for further examination.
