What is Basic Earnings Per Share?
Basic earnings per share is a financial ratio that measures net income earned by or available to each common stockholder. The basic earnings per share ratio is often called earnings per share, EPS, and net income per share.
Basic earnings per share represent a measure of the success of the company. It shows the portion of generated earnings assigned to each common stock. Basic earnings per share provide an overview regarding the dispersion of income after taxes to the common shares. This measure also shows the company’s capacity to generate earnings from its operations.
They are stated with the income statement. Basic EPS are especially useful when the company’s capital structure is composed solely of common stocks.
What Does Basic EPS Mean?
Basic earnings per share is the amount of a company’s earnings allocable to each share of its common stock. It is a useful measure of performance for companies with simplified capital structures. If a business only has common stock in its capital structure, the company presents only its basic earnings per share for income from continuing operations and net income. This information is reported on its income statement. If there are situations under which more shares might be issued, such as when stock options are outstanding, then diluted earnings per share must also be reported. As the name implies, diluted earnings per share present the lowest possible earnings per share, based on assumptions that all possible shares are issued.
The formula for basic earnings per share is:
Basic EPS = Earnings / Number of Shares
Basic EPS = (Net income - Preferred dividends) / (Weighted average of common shares outstanding during the period)
Preferred dividends have to be taken out of net income because this money is not available to common stock holders. Preferred shareholders often have rights to dividends before common stockholders, so this money must be set-aside for preferred shareholders. Preferred stock can be issued as noncumulative and cumulative preferred stock. If noncumulative preferred shares are issued, only the preferred dividends that are actually declared must be subtracted from net income.
Cumulative preferred shares are more inclusive. If cumulative preferred shares are issued, all preferred dividends whether declared or not must be subtracted from net income to establish the earnings available to common shareholders.
When calculating basic earnings per share, incorporate into the numerator an adjustment for dividends. You should deduct from the profit or loss the after-tax amount of any dividends declared on non-cumulative preferred stock, as well as the after-tax amount of any preferred stock dividends, even if the dividends are not declared; this does not include any dividends paid or declared during the current period that relate to previous periods.
Also, you should incorporate the following adjustments into the denominator of the basic earnings per share calculation:
- Contingent stock. If there is contingently issuable stock, treat it as though it were outstanding as of the date when there are no circumstances under which the shares would not be issued.
- Weighted-average shares. Use the weighted-average number of shares during the period in the denominator. You do this by adjusting the number of shares outstanding at the beginning of the reporting period for common shares repurchased or issued in the period. This adjustment is based on the proportion of the days in the reporting period that the shares are outstanding.
If a company has a complex capital structure where the need to issue additional shares might arise then diluted EPS is considered to be a more precise metric than basic EPS. Diluted EPS takes into account all of the outstanding dilutive securities that could potentially be exercised (such as stock options and convertible preferred stock) and shows how such an action would affect earnings per share.
Companies with a complex capital structure must report both basic EPS and diluted EPS to provide a more accurate picture of their earnings. The main difference between basic EPS and diluted EPS is that the latter factors in the assumption that all convertible securities will be exercised. As such, basic EPS will always be the higher of the two since the denominator will always be bigger for the diluted EPS calculation.
Basic Earnings Per Share Example
A company reports net income of $100 million after expenses and taxes. The company issues preferred dividends to its preferred stockholders of $23 million, leaving earnings available to common shareholders of $77 million. The company had 100 million common shares outstanding at the beginning of the year and issued 20 million new common shares in the second half of the year. As a result, the weighted average number of common shares outstanding is 110 million: 100 million shares for the first half of the year and 120 million shares for the second half of the year (100 x 0.5) + (120 x 0.5) = 110. Dividing the earnings available to common shareholders of $77 million by the weighted average number of common shares outstanding of 110 million gives a basic EPS of $0.70.
ABC company earns a profit of $1,000,000 net of taxes in Year 1. In addition, ABC owes $200,000 in dividends to the holders of its cumulative preferred stock. ABC calculates the numerator of its basic earnings per share as follows:
$1,000,000 Profit – $200,000 Dividends = $800,000
ABC had 4,000,000 common shares outstanding at the beginning of Year 1. In addition, it sold 200,000 shares on April 1 and 400,000 shares on October 1. It also issued 500,000 shares on July 1 to the owners of a newly-acquired subsidiary. Finally, it bought back 60,000 shares on December 1. ABC calculates the weighted-average number of common shares outstanding as follows:
|Date||Shares||Weighting (months)||Weighted Average|
ABC’s basic earnings per share is:
$800,000 adjusted profits ÷ 4,495,000 weighted-average shares = $0.18 per share