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Chapter19: Share-Based Compensation and Earnings Per Share

Basic Earnings Per Share

p. 1083

A firm is said to have a simple capital structure a firm that has no potential common shares (outstanding securities that could potentially dilute earnings per share). if it has no outstanding securities that could potentially dilute earnings per share. In this context, to dilute means to reduce earnings per share. For instance, if a firm has convertible bonds outstanding and those bonds are converted, the resulting increase in common shares could decrease (or dilute) earnings per share. That is, the new shares replaced by the converted bonds might participate in future earnings. So convertible bonds are referred to as potential common shares Securities that, while not being common stock may become common stock through their exercise, conversion, or issuance and therefore dilute (reduce) earnings per share.. Other potential common shares are convertible preferred stock, stock options, and contingently issuable shares. We will see how the potentially dilutive effects of these securities are included in the calculation of EPS later in this chapter. Now, though, our focus is on the calculation of EPS for a simple capital structure—when no potential common shares are present. In these cases, the calculation is referred to as basic EPS computed by dividing income available to common stockholders (net income less any preferred stock dividends) by the weighted-average number of common shares outstanding for the period., and is simply earnings available to common shareholders divided by the weighted-average number of common shares outstanding.

 

A firm has a simple capital structure if it has no potential common shares.

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Basic EPS reflects no dilution, only shares now outstanding.

In the most elemental setting, earnings per share (or net loss per share) is merely a firm's net income (or net loss) divided by the number of shares of common stock outstanding throughout the year. The calculation becomes more demanding (a) when the number of shares has changed during the reporting period, (b) when the earnings available to common shareholders are diminished by dividends to preferred shareholders, or (c) when we attempt to take into account the impending effect of potential common shares (which we do in a later section of the chapter). To illustrate the calculation of EPS in each of its dimensions, we will use only one example in this chapter. We'll start with the most basic situation and then add one new element at a time until we have considered all the principal ways the calculation can be affected. In this way you can see the effect of each component of earnings per share, not just in isolation, but in relation to the effects of other components as well. The basic calculation is shown in Illustration 19-4.

 

EPS expresses a firm’s profitability on a per share basis.

ILLUSTRATION 19-4

Fundamental Calculation

In the most elemental setting, earnings per share is simply a company's earnings divided by the number of shares outstanding.

  Sovran Financial Corporation reported net income of $154 million in 2011 (tax rate 40%). Its capital structure consisted of:

Common Stock

Jan. 1

60 million common shares were outstanding (amounts in millions, except per share amount)

Basic EPS:

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Issuance of New Shares

Because the shares discussed in Illustration 19-4 remained unchanged throughout the year, the denominator of the EPS calculation is simply the number of shares outstanding. But if the number of shares has changed, it's necessary to find the weighted average of the shares outstanding during the period the earnings were generated. For instance, if an additional 12 million shares had been issued on March 1 of the year just ended, we calculate the weighted-average number of shares to be 70 million as demonstrated in Illustration 19-5 on the next page.

   Because the new shares were outstanding only 10 months, or 10/12 of the year, we increase the 60 million shares already outstanding by the additional shares—weighted by the fraction of the year (10/12) they were outstanding. The weighted average is 60 + 12 (10/12) = 60 + 10 = 70 million shares. The reason for time-weighting the shares issued is that the resources the stock sale provides the company are available for generating income only after the date the shares are sold. So, weighting is necessary to make the shares in the fraction's denominator consistent with the income in its numerator.

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p. 1084

ILLUSTRATION 19-5

Weighted Average

Any new shares issued are time-weighted by the fraction of the period they were outstanding and then added to the number of shares outstanding for the entire period.

  Sovran Financial Corporation reported net income of $154 million for 2011 (tax rate 40%). Its capital structure included:

Common Stock

Jan. 1

60 million common shares were outstanding

Mar. 1

12 million new shares were sold
(amounts in millions, except per share amount)

Basic EPS:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_eq1906.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

Stock Dividends and Stock Splits

Recall that a stock dividend or a stock split is a distribution of additional shares to existing shareholders. But there's an important and fundamental difference between the increase in shares caused by a stock dividend and an increase from selling new shares. When new shares are sold, both assets and shareholders' equity are increased by an additional investment in the firm by shareholders. On the other hand, a stock dividend or stock split merely increases the number of shares without affecting the firm's assets. In effect, the same pie is divided into more pieces. The result is a larger number of less valuable shares. This fundamental change in the nature of the shares is reflected in a calculation of EPS by simply increasing the number of shares.

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   In Illustration 19-6, notice that the additional shares created by the stock dividend are not weighted for the time period they were outstanding. Instead, the increase is treated as if it occurred at the beginning of the year.

ILLUSTRATION 19-6

Stock Dividends and Stock Splits

Shares outstanding prior to the stock dividend are retroactively restated to reflect the 10% increase in shares— that is, treated as if the distribution occurred at the beginning of the period.

  Sovran Financial Corporation reported net income of $154 million in 2009 (tax rate 40%). Its capital structure included:

Common Stock

Jan. 1

60 million common shares were outstanding

Mar. 1

12 million new shares were sold

June 17

A 10% stock dividend was distributed
(amounts in millions, except per share amount)

Basic EPS:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_un1901.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

   The number of shares outstanding after a 10% stock dividend is 1.10 times higher than before. This multiple is applied to both the beginning shares and the new shares sold before the stock distribution. If this had been a 25% stock dividend, the multiple would have been 1.25; a 2-for-1 stock split means a multiple of 2; and so on.

   Notice that EPS without the 10% stock dividend ($2.20) is 10% more than it is with the stock distribution ($2). This is caused by the increase in the number of shares. But, unlike a sale of new shares, this should not be interpreted as a “dilution” of earnings per share. Shareholders' interests in their company's earnings have not been diluted. Instead, each shareholder's interest is represented by more—though less valuable—shares.

p. 1085

   A simplistic but convenient way to view the effect is to think of the predistribution shares as having been “blue.” After the stock dividend, the more valuable “blue” shares are gone, replaced by a larger number of, let's say, “green” shares. From now on, we compute the earnings per “green” share, whereas we previously calculated earnings per “blue” share. We restate the number of shares retroactively to reflect the stock dividend, as if the shares always had been “green.” After all, our intent is to let the calculation reflect the fundamental change in the nature of the shares.

  
ADDITIONAL CONSIDERATION

When last year's EPS is reported in the current year's comparative income statements, it too should reflect the increased shares from the stock dividend. For instance, suppose EPS was $2.09 for 2011: $115 million net income divided by 55 million weighted-average shares. When reported again for comparison purposes in the 2011 comparative income statements, that figure would be restated to reflect the 10% stock dividend [$115 ÷ (55 × 1.10) = $1.90]:

Earnings per Share:

2011

2010

$2.00

$1.90

   The EPS numbers now are comparable—both reflect the stock dividend. Otherwise we would be comparing earnings per “green” share with earnings per “blue” share; this way both are earnings per “green” share.

  

Reacquired Shares

If shares were reacquired during the period (either retired or as treasury stock), the weighted-average number of shares is reduced. The number of reacquired shares is time-weighted for the fraction of the year they were  not  outstanding, prior to being subtracted from the number of shares outstanding during the period. Let's modify our continuing illustration to assume 8 million shares were reacquired on October 1 as treasury stock (Illustration 19-7).

ILLUSTRATION 19-7

Reacquired Shares

The 8 million shares reacquired as treasury stock are weighted by (3/12) to reflect the fact they were not outstanding the last three months of the year.

  Sovran Financial Corporation reported net income of $154 million in 2011 (tax rate 40%). Its capital structure included:

Common Stock

Jan. 1

60 million common shares outstanding

Mar. 1

12 million new shares were sold

June 17

A 10% stock dividend was distributed

Oct. 1

8 million shares were reacquired as treasury stock (amounts in millions, except per share amounts)

Basic EPS:

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*Not necessary for the treasury shares since they were reacquired after the stock dividend and thus already reflect the adjustment (that is, the shares repurchased are 8 million “new green” shares).

p. 1086

   Compare the adjustment for treasury shares with the adjustment for new shares sold. Each is time-weighted for the fraction of the year the shares were or were not outstanding. But also notice two differences. The new shares are added, while the reacquired shares are subtracted. The second difference is that the reacquired shares are not multiplied by 1.10 to adjust for the 10% stock dividend. The reason is the shares were repurchased after the June 17 stock dividend; the reacquired shares are 8 million of the new post-distribution shares. (To use our earlier representation, these are 8 million “green” shares.) To generalize, when a stock distribution occurs during the reporting period, any sales or purchases of shares that occur before the distribution are increased by the distribution. But the stock distribution does not increase the number of shares sold or purchased, if any, after the distribution.

 

The adjustment for reacquired shares is the same as for new shares sold except the shares are deducted rather than added.

Any sales or purchases of shares that occur before, but not after, a stock dividend or split are affected by the distribution.

Earnings Available to Common Shareholders

The denominator in an EPS calculation is the weighted-average number of common shares outstanding. Logically, the numerator should similarly represent earnings available to common shareholders. This was automatic in our illustrations to this point because the only shares outstanding were common shares. But when a senior class of shareholders (like preferred shareholders) is entitled to a specified allocation of earnings (like preferred dividends), those amounts are subtracted from earnings before calculating earnings per share.17 This is demonstrated in Illustration 19-8.

 

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ILLUSTRATION 19-8

Preferred Dividends

Preferred dividends are subtracted from net income so that “earnings available to common shareholders” is divided by the weighted-average number of common shares.

  Sovran Financial Corporation reported net income of $154 million in 2011 (tax rate 40%). Its capital structure included:

Common Stock

January 1

60 million common shares were outstanding

March 1

12 million new shares were sold

June 17

A 10% stock dividend was distributed

October 1

8 million shares were reacquired as treasury stock

Preferred Stock, Nonconvertible

January 1–December 31

5 million 8%, $10 par, shares
(amounts in millions, except per share amount)

Basic EPS:

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*8% × $10 par × 5 million shares.

   Suppose no dividends were declared for the year. Should we adjust for preferred dividends? Yes, if the preferred stock is cumulative—and most preferred stock is. This means that when dividends are not declared, the unpaid dividends accumulate to be paid in a future year when (if) dividends are subsequently declared. Obviously, the presumption is that, although the year's dividend preference isn't distributed this year, it eventually will be paid.

We have encountered no potential common shares to this point in our continuing illustration. As a result, we have what is referred to as a simple capital structure. (Although, at this point, you may question this label.) For a simple capital structure, a single presentation of basic earnings per common share is appropriate. We turn our attention now to situations described as complex capital structures. In these situations, two separate presentations are required: basic EPS and diluted EPS.

 

Preferred dividends reduce earnings available to common shareholders unless the preferred stock is noncumulative and no dividends were declared that year.




17You learned in Chapter 18 that when dividends are declared, preferred shareholders have a preference (over common shareholders) to a specified amount.

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