fEarnings per Share 

In the next few articles, the term "earnings" and "earnings per share" will be used very frequently.  In fact, in the analyses that follow, earnings will be paramount; they'll be used in some shape or form pretty continuously.  The main focus will be on earnings per share.  We're focused on buying shares of common stock, so normalizing the earnings to the number of shares makes sense. 

So before discussing Earnings per Share or EPS, the term should be defined. EPS (Earnings per Share) is Net Income (after dividends have been paid on preferred shares) divided by the number of shares outstanding.  Since the number of outstanding shares fluctuates a lot, the "profit" is actually dividend by the average number of outstanding shares.  Each of those two new terms needs to be discussed.

Shares in a Corporation

What is a corporation? 

Let's talk about shares in a company.  When any corporation, private or public, is created, a corporate charter (also called the articles of incorporation) is written.  The charter defines what the corporation is, its objectives, how it's structured and how the capital stock or ownersfhip interest is to be divifded up.  It defines how people can have a share in the capital stock of the new entity.  The charter stipulates how many shares (and of what type) the company is authorized to issue.

A corporation is, in a sense, a legal fiction.  It's not a biological entity, but in many respects it is a 'person': it can own property; open a bank account; borrow money; hire people; get sued; sue other people; it can potentially live forever; get taxed but it can't vote.  It can 'marry' another corporation, a merger; it can get 'divorced' too!  A corporation is a 'legal person'; it's just not a biological one.  The advantage of a corporation, as a separate entity, is that it shields its owners from potential liability.  The corporation is taxed on its profits and it can share its profits with its owners in the from of a dividend.

What are common and preferred shares?

A company may issue common shares and/or preferred shares in its capital stock.  Common shares or common stock is a financial security that designates the ownership interest in a corporation.   If you own all the common stock, you own the entire company.  If you own one share out of 5 billion, you own one five billionth of the fcompany.  Owners of the company elect the board of directors who are charged with, among other things, looking out for the interests of the owners.  The board of directors appoints management to run the corporation.  Owners of common stock or ordinary shares have the lowest claim on the assets or earnings of a company.

There's another potential group of shareholders called preferred shareholders.  There may be different classes of preferred shares.  Their rights are defined in the corporate charter.  However, suffice it to say that usually, if a dividend is to be paid, preferred shareholders receive a dividend before common shareholders.  Sometimes, preferred shares are convertible into common shares; many times they are not.  Once they're converted, the preferred shares no longer exist!

Outstanding shares

The corporate charter stipulates how many shares the company is authorized to issue; the company cannot issue more than this limit without approval by the shareholders.  Approval means that the terms of the corporate charter need to be amended.  Shares may be issued, unissued or may be part of the treasury stock.  Unissued shares is an easy concept.   If the corporation has authorization to issue 10 billion shares, but has only issued one hundred million, then 9.9 billion shares are unissued.

Issued shares can be divided into two categories: outstanding and treasury stock.  Outstanding shares are those bought and sold by investors.  Treasury stock or treasury shares consists of shares that the company has repurchased.  The corporation, this legal 'person,' has purchased shares of the company.  The shares are still issued, but they are no longer outstanding.  Treasury shares aren't paid a dividend, nor do they have voting rights.

Average number of outstanding shares 

Companies often buy their and or sell their shares all the time, so the number of outstanding shares can change from day-to-day.  In calculations, if the number of outstanding shares is required, it's best to take the average number of outstanding shares in the period.  So, if you're looking at a quarter, often the average is calculated using the number of outstanding shares at the start of the quarter and the number at the end.

Net Income

Net Income is another term for profit. You'll hear a range of different was of discussing income; for example, operating income is a term that's discussed often. However, Net Income has a special meaning.  In some upcoming blogs, a company called Clayton Homes will be used as an example.  Even though the company is no longer public, it was bought by Warren Buffett, it's still a good example.  Using a "dead" company also avoids any confusion that I am suggesting you go out and buy it!  I used to follow this company closely and bought it regularly; however, it turns out that Warren Buffett has more financial resources than do I.  Since you're going to see this company in later blogs, I may as well use it here too.  The income statement for Clayton Homes from 1999 will be used as an example.

The Income Statement for Clayton Homes for Fiscal Year 1999

The income statement starts with revenues earned over a given period of time, then subtracts all the expenses associated with those revenues for the same period of time. The last figure on the income statement, the proverbial bottom line, is net income—that's where the expression "what's the bottom line" comes from.   In this quarter, Clayton Homes generated $154.97 million in net income.

For completeness, the term Net Income needs to be discussed a little further. You could take Net Income from the most recent fiscal year; alternatively, you could take Net Income for each of the most recent four quarters, add them together and use that figure for Net Income for a year of business.  Note: this method won't necessarily coincide with a fiscal or calendar year, but it gives you then figure for the most recent year of business.  Finally, if you're interested in considering what the company is doing in the future, you might want to look at Net Income projected for the next, forthcoming, four quarters and use that figure for Net Income.  In the blog on the PE ratio, the topic of earnings based on rolling four quarters and the issue of project earnings were discussed.

So, there are lots of ways to figure Net Income, but it depends on your outlook. The calculation is the same.  It just depends on what period of time is of interest to you.

So if we have a value for the net income in a given period, to figure EPS you need to know the shares outstanding.  There's a wrinkle in this calculation too; it's similar to the discussion on Net Income.

Determining the average number of outstanding shares 

First off, as discussed previously, the number of shares outstanding can change from day to day.  A company can issue more shares, if shareholders and the board approves; the company can also buy back shares.  If the shares are repurchased, they're still considered issued but no longer outstanding. So, to figure out the number of shares outstanding, some people take the number of shares on January 1 add that figure to the number outstanding the following December 31, then divide by two, which yields an insight into the average number of shares outstanding that year.  Others take the figure on the day of interest, for example, if you're trying to figure out EPS on September 2, 2008, you could divide the most recent four quarters of net income by the number of shares outstanding on the second day of September.

For the example of Clayton Homes, let's say that on January 1, 1999, there were 145,464,600 shares outstanding.  During the year, the company engaged in a share buy-back program so that by the end of the year, on December 31, 1999, there were 144,195,200 shares outstanding.  The average number of shares outstanding during the year is found by adding these two numbers together, then dividing by two.  The result is 144,829,900 shares.

Different Opinions on Earnings per Share

The EPS figure is critically dependent on how you define earnings and how you define the number of outstanding shares.   Conservative investors like conservative determinations as, all else being equal, these could lead to more upside than downside.  A number of years ago, in fact in February of 1997, the powers that be, FASB, issued the Statement of Financial Accounting Standards No. 128, which created standards for calculating and publishing earnings per share.  The statement included a standard on "fully diluted" earnings per share, the EPS value that is now reported by companies.

Basic earnings per share

Basic earnings per share, which was the norm before 1997, uses as a basis the average number of outstanding shares in the determination of an EPS figure.  So, for example, if 1.2 million shares were outstanding on January 1 and only 1.0 million outstanding on March 31, the average number of shares outstanding for the quarter would be taken as 1.1 million?the average of 1.0 and 1.2 million.  This figure of 1.1 million would then be used to calculated the EPS figure from net income.

To calculate the basic earnings per share figure for Clayton Homes in the example above, you would take the net income figure of $154,968,000 and divide it by the average number of shares outstanding, 144,829,900, which results in a figure of $1.07 per share.

Companies often offer stock options as an incentive to employees.  They sometimes have debentures, which are essentially bonds not secured by the assets of the company, but that may be converted into common stock; there could be warrants (a right to acquire common stock from the company often at a lower price than the market price when the right was issued) and there could be prefered shares with a feature that permits them to be converted into common shares.  These "potential" shares are not outstanding, but if the rights were exercised, the number of oustanding shares would increase, thus the EPS would fall.

For the example of Clayton Homes above, let's say that on January 1, 1999, while there were 145,464,600 shares outstanding, if all convertible instruments were exercised, there would be 147,675,100 shares on the market.  While on December 31, 1999, while there were 144,195,200 shares outstanding, if every single potential share joined the pool, there would be 144,717,400 shares outstanding.  In terms of the fully diluted number of shares, the average number is 146,196,200.

Investors wanted clarification on what could happen to their investment.  As a result, FASB issued a directive requiring that companies report fully diluted EPS figures.

Fully diluted earnings per share

The fully diluted EPS number is calculated in a similar fashion to the basic figure; however, once the average number of outstanding shares is determined, it is increased by the number of shares that could be outstanding if all convertible instruments were became common stock.  A description of some of those instruments is discussed above.  For technology companies, the number of outstanding shares could increase by as much as ten to twenty percent if all convertible instruments are exercised.  The fully diluted EPS figure is always higher than the figure for basic earnings.

To calculate the fully diluted earnings per share figure for Clayton Homes in the example above, you would take the net income figure of $154,968,000 and divide it by the average number of "fully diluted" shares outstanding; that is, the average number of shares that would be outstanding if every convertible instrument were exercised.  That figure was previously calculated to be 146,196,200.  Then this larger number is dividend into the net income figure, the fully diluted earnings per share figure is $1.06.

Consistency is important 

The number of shares used in your calculation should mirror the time frame used in the calculation for Net Income. So, for example, if you're projecting net income for the upcoming for quarters, you should also estimate the shares outstanding in that same period of time if you expect they would be different.

In Summary

A corporation is a 'legal person' with many rights that a biological person can have.  Unlike real people, a corporation is owned by either people or another corporation (or similar entity).  The ownership interest is divided up into shares of the corporation.  One way to present the earnings of the company is to divide them by the number of outfstanding shares.  Determining the number of outstanding shares is straightforward, but a more conservative approach is to look at fully diluted earnings: earnings per share calculated if all convertible instruments were converted into shares of stock.

EPS is calculated for a number of reasons. It allows shareholders to get a handle on the earnings generated per share of the company that they own. More importantly, EPS is used in an important calculation called the PE or Price/Earnings ratio. That concept is discussed in another article.