115 CFA
File: Financial Analysis - Reading 21 - 7. Earnings per Share

7. Earnings per Share

h. describe how earnings per share is calculated and calculate and interpret a company's earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures;

i. distinguish between dilutive and antidilutive securities and describe the implications of each for the earnings per share calculation;

What does it mean for a company's capital structure to be "simple"?
A company's capital structure is simple if it consists of only common stock or includes no potential common stock that upon conversion or exercise could dilute earnings per common share.

What does it mean for a company's capital structure to be "complex"?
A complex capital structure contains securities that could have a dilutive effect on earnings per common share. Dilutive securities are securities that, upon conversion or exercise, could dilute earnings per share. These securities include options, warrants, convertible bonds, and preferred stocks.

How do you calculate Earnings Per Share in a simple capital structure?
$$EPS = \frac{net\ income - preferred\ dividends}{weighted\ average\ number\ of\ shares\ outstanding}$$

Why are preferred dividends subtracted from net income in the earnings per share calculation?
The current year's preferred dividends are subtracted from net income because EPS refers to earnings available to the common shareholder. Common stock dividends are not subtracted from net income.

Why is the weighted average number of common shares outstanding used in the EPS calculation?
Since the number of common shares outstanding may change over the year, the weighted average is used to compute EPS. The weighted average number of common shares is the number of shares outstanding during the year weighted by the portion of the year they were outstanding.

What two EPS calculations do companies with complex capital structures have to report?
Basic EPS and diluted EPS

What are antidilutive securities?
Antidilutive securities are those that, upon conversion or exercise, increase earnings per share or reduce loss per share.

What is the purpose of the diluted EPS calculation?
Diluted EPS shows the maximum potential adverse effect on EPS if dilutive securities are converted to common stock. The purpose is to show the "worst case" scenario.

What is the diluted EPS calculation?
$$Diluted\ EPS = \frac{net\ income - preferred\ dividends + adjustments\ for\ conversions}{weighted\ average\ number\ of\ shares\ outstanding + equivalent\ number\ of\ potential\ common\ shares\ from\ the\ conversion\ of\ all\ outstanding\ dilutive\ securities}$$

  • CFA