14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance

Calculating Earnings per Share

Earnings per share is the profit a company earns for each of its outstanding common shares. Both the balance sheet and income statement are needed to calculate EPS. The balance sheet provides details on the preferred dividend rate, the total par value of the preferred stock, and the number of common shares outstanding. The income statement indicates the net income for the period. The formula to calculate basic earnings per share is:

By removing the preferred dividends from net income, the numerator represents the profit available to common shareholders. Because preferred dividends represent the amount of net income to be distributed to preferred shareholders, this portion of the income is obviously not available for common shareholders. While there are a number of variations of measuring a company’s profit used in the financial world, such as NOPAT (net operating profit after taxes) and EBITDA (earnings before interest, taxes, depreciation, and amortization), GAAP requires companies to calculate EPS based on a corporation’s net income, as this amount appears directly on a company’s income statement, which for public companies must be audited.

In the denominator, only common shares are used to determine earnings per share because EPS is a measure of earnings for each common share of stock. The denominator can fluctuate throughout the year as a company issues and buys back shares of its own stock. The weighted average number of shares is used on the denominator because of this fluctuation. To illustrate, assume that a corporation began the year with 600 shares of common stock outstanding and then on April 1 issued 1,000 more shares. During the period January 1 to March 31, the company had the original 600 shares outstanding. Once the new shares were issued, the company had the original 600 plus the new 1,000 shares, for a total of 1,600 shares for each of the next nine months—from April 1 to December 31. To determine the weighted average shares, apply these fractional weights to both of the stock amounts, as shown in Figure 14.15.

Figure 14.15 Weighted Shares. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

If the shares were not weighted, the calculation would not consider the time period during which the shares were outstanding.

To illustrate how EPS is calculated, assume Sanaron Company earns $50,000 in net income during 2020. During the year, the company also declared a $10,000 dividend on preferred stock and a $14,000 dividend on common stock. The company had 5,000 common shares outstanding the entire year along with 2,000 preferred shares. Sanaron has generated $8 of earnings ($50,000 less the $10,000 of preferred dividends) for each of the 5,000 common shares of stock it has outstanding.

Measuring Performance with EPS

EPS is a key profitability measure that both current and potential common stockholders monitor. Its importance is accentuated by the fact that GAAP requires public companies to report EPS on the face of a company’s income statement. This is only ratio that requires such prominent reporting. If fact, public companies are required to report two different earnings per share amounts on their income statements—basic and diluted. We’ve illustrated the calculation of basic EPS. Diluted EPS, which is not demonstrated here, involves the consideration of all securities such as stocks and bonds that could potentially dilute, or reduce, the basic EPS.

Common stock shares are normally purchased by investors to generate income through dividends or to sell at a profit in the future. Investors realize that inadequate EPS can result in poor or inconsistent dividend payments and fluctuating stock prices. As such, companies seek to produce EPS amounts that rise each period. However, an increase in EPS may not always reflect favorable performance, as there are multiple reasons that EPS may increase. One way EPS can increase is because of increased net income. On the other hand, it can also increase when a company buys back its own shares of stock. For example, assume that Ranadune Enterprises generated net income of $15,000 in 2020. In addition, 20,000 shares of common stock and no preferred stock were outstanding throughout 2020. On January 1, 2020, the company buys back 2,500 shares of its common stock and holds them as treasury shares. Net income for 2020 stayed static at $15,000. Just before the repurchasing of the stock, the company’s EPS is $0.75 per share:

The purchase of treasury stock in 2020 reduces the common shares outstanding to 17,500 because treasury shares are considered issued but not outstanding (20,000 − 2,500). EPS for 2020 is now $0.86 per share even though earnings remains the same.

This increase in EPS occurred because the net income is now spread over fewer shares of stock. Similarly, EPS can decline even when a company’s net income increases if the number of shares increases at a higher degree than net income. Unfortunately, managers understand how the number of shares outstanding can affect EPS and are often in position to manipulate EPS by creating transactions that target a desired EPS number.

Earnings per share is interpreted differently by different analysts. Some financial experts favor companies with higher EPS values. The reasoning is that a higher EPS is a reflection of strong earnings and therefore a good investment prospect. A more meaningful analysis occurs when EPS is tracked over a number of years, such as when presented in the comparative income statements for Cracker Barrel Old Country Store, Inc.’s respective year ends in 2017, 2016, and 2015 shown in Figure 14.16.¹⁹ Cracker Barrel’s basic EPS is labeled as “net income per share: basic.”

Figure 14.16 Consolidated Statements of Income for Cracker Barrel. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Most analysts believe that a consistent improvement in EPS year after year is the indication of continuous improvement in the earning power of a company. This is what is seen in Cracker Barrel’s EPS amounts over each of the three years reported, moving from $6.85 to $7.91 to $8.40. However, it is important to remember that EPS is calculated on historical data, which is not always predictive of the future. In addition, when EPS is used to compare different companies, significant differences may exist. If companies are in the same industry, that comparison may be more valuable than if they are in different industries. Basically, EPS should be a tool used in decision-making, utilized alongside other analytic tools.