1. Chapter 27
Earnings Per Share

2. 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.

3. 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.

4. 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.

5. 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.

6. 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:

7. 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:

8. 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:

9. 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:

10. 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.

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

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

13. 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.

14. 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.

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

16. Earnings per share – diluted calculation

17. 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.

18. 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.

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

20. 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.

21. 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.

22. 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

23. 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 X1.

24. BEPS – rights issue
Four-step approach.

25. Rights issue calculation
Assume 50p ordinary shares had £4 market value
Assume company offered a rights issue of
One 50p £3.25
For every two 50p shares held.

26. 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

27. 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.

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

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

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

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

32. Diluted EPS – share optionsA P S

33. Diluted EPS – convertible bondsA I

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

35. Diluted EPS – convertible preference shares (Continued)

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

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

38. 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

39. 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.

40. 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?

41. 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?