Slide 27.1
Chapter 27
Earnings Per Share
Slide 27.2
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.
Slide 27.3
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.
Slide 27.4
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.
Slide 27.5
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.
Slide 27.6
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:
Slide 27.7
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:
Slide 27.8
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:
Slide 27.9
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:
Slide 27.10
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.
Slide 27.11
Why EPS is important
 Component of PE ratio
 Typical press extract.

EPS



35.95
8.65
57.40
Slide 27.12
Factors that affect the PE ratio
Investors’ confidence – external influences
 International scene
 National economy
 Industry sector.
Slide 27.13
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.
Slide 27.14
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.
Slide 27.15
Earnings per share – basic
calculation
Basic EPS = earnings/weighted number of ordinary
shares
Slide 27.16
Earnings per share – diluted calculation
Slide 27.17
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.
Slide 27.18
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.
Slide 27.19
BEPS calculation
Watts plc share capital
 1m 50p ordinary shares
 1m £1 10% preference shares
Watts post tax profit for 20X1
 £1,250,000.
Slide 27.20
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.
Slide 27.21
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.
Slide 27.22
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
£
Slide 27.23
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 31.5.20X1.
£
£
Slide 27.24
BEPS – rights issue
Four-step approach.
Slide 27.25
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.
£
£
£
£
Slide 27.26
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
Slide 27.27
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.
Slide 27.28
Rights issue calculation (Continued)
Further adjustment to recognise bonus element.
£
£
£
£
Slide 27.29
Rights issue calculation (Continued)
Adjusted number of shares for current year.
No. of shares
Slide 27.30
Rights issue calculation (Continued)
Adjust previous year for bonus element.
£
£
£
£
Slide 27.31
Diluted EPS
Dilution may arise from:
Convertible bonds
Convertible preference shares
Share options
Share warrants.
Slide 27.32
Diluted EPS – share options
£
A
P
A
S
£
£
£
Slide 27.33
Diluted EPS – convertible bonds
A
A
I
A
Slide 27.34
Diluted EPS – convertible preference shares
Assume that Watts had at 31.12.20X1.
£
A
P
C
C
£
£
Slide 27.35
Diluted EPS – convertible preference
shares (Continued)
£
£
£
Slide 27.36
Diluted EPS – several potential dilutions
 Assume that Watts had at 31.12.20X1.
£
A
£
P
£
A
S
£
C
C
£
£
£
Slide 27.37
Diluted EPS – several potential dilutions
(Continued)
Increase in
earnings
Increase in number
Earnings per
of ordinary shares incremental share
Slide 27.38
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
Slide 27.39
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.
Slide 27.40
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?
Slide 27.41
Review questions (Continued)
6. 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
7. 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?