Chapter 27 Earnings Per Share

Objectives 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.

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.

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.

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.

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:

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:

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:

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:

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.

Why EPS is important Component of PE ratio Typical press extract. EPS 35.95 8.65 57.40

Factors that affect the PE ratio Investors’ confidence – external influences International scene National economy Industry sector.

Factors that affect the PE ratio (Continued) Investors’ confidence – external influences Current 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.

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.

Earnings per share – basic calculation Basic EPS = earnings/weighted number of ordinary shares

Earnings per share – diluted calculation

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.

Limitations of EPS as performance measure Based on historical earnings No account of inflation Real growth differing from apparent growth Inter-company comparison adversely affected Management choice over accounting policies Changes in capital structure.

BEPS calculation Watts plc share capital 1m 50p ordinary shares 1m £1 10% preference shares Watts post tax profit for 20X1 £1,250,000.

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.

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.

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

BEPS calculation – buyback at market 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. £

BEPS – rights issue Four-step approach.

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. £

Rights issue calculation (Continued) Bonus element. £ 2 shares at fair value of £4 each prior to rights issue 1 share at discounted rights issue price of £3.25 each 3 shares at fair value after issue (i.e. ex-rights) The theoretical ex-rights price is 11.25/3 shares The bonus element is fair value 4 less 3.75

Rights issue calculation (Continued) 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.

Rights issue calculation (Continued) Further adjustment to recognise bonus element. £

Rights issue calculation (Continued) Adjusted number of shares for current year. No. of shares

Rights issue calculation (Continued) Adjust previous year for bonus element. £

Diluted EPS Dilution may arise from: Convertible bonds Convertible preference shares Share options Share warrants.

Diluted EPS – share options £ A P S

Diluted EPS – convertible bonds A I

Diluted EPS – convertible preference shares Assume that Watts had at 31.12.20X1. A £ P £ C £ C

Diluted EPS – convertible preference shares (Continued) £

Diluted EPS – several potential dilutions Assume that Watts had at 31.12.20X1. £ P S A C

Diluted EPS – several potential dilutions (Continued) Increase in earnings Increase in number of ordinary shares Earnings per incremental share

Diluted EPS – several potential dilutions (Continued) Step 2: Determine the potential ordinary shares to include in the computation of diluted earnings per share Net profit attributable to continuing operations Ordinary shares Per share

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.

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?

Review questions (Continued) 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 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?