BASIC EARNINGS PER SHARE

Basic earnings per share is a rough measurement of the amount of a company's profit that can be
allocated to one share of its common stock. Businesses with simple capital structures, where only
common stock has been issued, need only release this ratio to reveal their profitability. It is reported in a
company's income statement and is especially informative for businesses with only common stock in
their capital structures.

Basic earnings per share (EPS) tells investors how much of a firm's net income was allotted to each share
of common stock. In other words, this is the amount of money each share of stock would receive if all of
the profits were distributed to the outstanding shares at the end of the year.

EPS, also called net income per share, is a financial, profitability and market prospect ratio that
measures the amount of net income earned per share of stock outstanding. Higher earnings per share is
always better than a lower ratio because this means the company is more profitable and the company
has more profits to distribute to its shareholders.

Although many investors don’t pay much attention to the EPS, a higher earnings per share ratio often
makes the stock price of a company rise. Since so many things can manipulate this ratio, investors tend
to look at it but don’t let it influence their decisions drastically.

EPS is a calculation that shows how profitable a company is on a shareholder basis. So a larger
company’s profits per share can be compared to smaller company’s profits per share. Obviously, this
calculation is heavily influenced on how many shares are outstanding. Thus, a larger company will have
to split its earning amongst many more shares of stock compared to a smaller company.

One of the first performance measures to check when analyzing a company’s financial health is its ability
to turn a profit. EPS is the industry standard that investors rely on to see how well a company has done.

Note that many companies do not have preferred shares, and for those companies, there are no
preferred dividends that need to be deducted. The reason preferred dividends are deducted is that EPS
represents only the earnings available to common shareholders, and preferred dividends need to be
paid out before common shareholders receive anything.

Formula

The Earnings per Share formula which divides net earnings available to common shareholders by the
average outstanding shares over a certain period of time indicates a company’s ability to produce net
profits for common shareholders.

Earnings per share or basic earnings per share is calculated by subtracting preferred dividends from net
income and dividing by the average common shares outstanding. There are several ways to calculate
earnings per share. Below are two versions of the earnings per share formula:

(Net Income−Preferred Dividends)

EPS=
End of Period Shares Outstanding

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 (Net Income−Preferred Dividends)
EPS=
Weighted Average S hares Outstanding

You will notice that the preferred dividends are removed from net income in the EPS calculation. This is
because EPS only measures the income available to common stockholders. Preferred dividends are set-
aside for the preferred shareholders and cannot belong to the common shareholders.

Net income available to shareholders for EPS purposes refers to net income less dividends on preferred
shares. Dividends payable to preferred shareholders are not available to common shareholders and
must be deducted to calculate EPS.

Understanding the Shareholders

Preferred Shares

There are two kinds of preferred shares that you already know about: Cumulative and Non-cumulative.
For cumulative preferred shares, the preferred shareholder’s entitlement must always be deducted
regardless of whether they are declared or paid. Only the current period’s dividends should be
considered, not any dividend in arrears. For non-cumulative preferred shares, the dividends should only
be deducted if the dividend has been declared.

Common Shares

To determine the total number of common shares, we calculate the weighted average number of
ordinary shares outstanding. A weighted average number is used instead of a year-end number
because the number of common shares frequently changes throughout the year. Most of the time
earning per share is calculated for year-end financial statements. Since companies often issue new stock
and buy back treasury stock throughout the year, the weighted average common shares are used in the
calculation. The weighted average common shares outstanding is can be simplified by adding the
beginning and ending outstanding shares and dividing by two.

Examples

1. A company reports net income of P100 million after expenses and taxes. The company issues
preferred dividends to its preferred stockholders of P23 million, leaving earnings available to
common shareholders of P77 million. The company had 100 million common shares outstanding at
the beginning of the year and issued 20 million new common shares in the second half of the year.

( Net Income−Preferred Dividends)

EPS=
Weighted Average Shares Outstanding

P 77 million
EPS=
110 million

EPS=P 0.070

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2. Quality Co. has net income during the year of P50,000. Since it is a small company, there are no
preferred shares outstanding. Quality Co. had 5,000 weighted average shares outstanding during the
year. Quality’s EPS is calculated like this.

( Net Income−Preferred Dividends)

EPS=
Weighted Average Shares Outstanding

P 50,000
EPS=
5,000

EPS=P 1 0

3. Lockdown Co. had earnings of P500 million and had 250 million shares of stock issued and
outstanding. What is its basic EPS?

(Net Income−Preferred Dividends)

EPS=
End of Period Shares Outstanding

P 5 million
EPS=
2 5 0 million

EPS=P 2.00

4. Assume that on January 1, 2020, ETB Co. had the following:

Preferred shares: 1,000,000 authorized, 400,000 issued and outstanding, P4 per share per year
dividend, cumulative, convertible at the rate of 1 preferred to 5 common shares.
Common shares: 5,000,000 authorized, 800,000 issued and outstanding, no par value and
no fixed dividend.
Calculate Basic EPS if net income was P2,234,000.

Step 1: Calculate net income available to common shareholders

Net Income P2,234,000
Less: Cumulative preferred dividends (P4 X 400,000) (1,600,000)
Net Income available to common shareholders 634,000

Step 2: Compute the Weighted Average Number of Shares Outstanding

In this example, there are no instances of common share issuance or repurchase. Therefore, the
weighted average is equal to the number of shares outstanding: 800,000

Step 3: Apply the Basic EPS formula

P 634,000
EPS=
800,000

EPS=P 0.79

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5. ETB Ltd has a net income of P1 million in the third quarter. The company announces dividends of
P250,000. Total shares outstanding is at 11,000,000.

(Net Income−Preferred Dividends)

EPS=
End of Period Shares Outstanding

P 1,000,000−P 250,000
EPS=
11,000,000

EPS=P 0 .068

6. PKL Company had P100 million in net income applicable to common shares for its most recent fiscal
year. It started that year with 20 million shares outstanding and ended that year with 15 million
shares outstanding. The basic EPS calculation would be:

( Net Income−Preferred Dividends)

EPS=
Weighted Average Shares Outstanding

P 100 million
EPS=
( 20 million+15 million )
2

EPS=P 5.71

Impact of Basic Earnings Per Share

Stocks trade on multiples of earnings per share, so a rise in basic EPS can cause a stock's price to
appreciate in line with the company's increasing earnings on a per share basis.

Increasing basic EPS, however, does not mean the company is generating greater earnings on a gross
basis. Companies can repurchase shares, decreasing their share count as a result and spread net income
less preferred dividends over fewer common shares. Basic EPS could increase even if absolute earnings
decrease with a falling common share count.

When you dive into the profit and loss statement of a company, you have to do it on two levels.

First, look at the entire business. How profitable is the company as a whole?

Second, examine the profits per share. Publicly traded companies are cut up into individual pieces, or
shares, and each of those shares represents part of the overall ownership pie. How much of the after-tax
income is each piece of the company entitled to receive?

For the individual investor, the second figure is what counts. If a company generates more profit each
year, but little of that additional profit makes its way to the shareholders on a per-share basis, the
prosperity of the business doesn't mean much to shareholders. It could be a terrible investment.