Profitability Analysis: Basic EPS

Basic Earnings per Share (BEPS): Assessing Profitability per Share

Introduction

Financial statement analysis is like peering through a company's financial microscope, examining various metrics to assess its profitability and performance. One crucial metric in this analysis is Basic Earnings per Share (BEPS), which acts as a microscope lens focusing on the profit generated for each common share held by shareholders. In this article, we will embark on a journey to understand BEPS: how it is calculated, how to interpret it, and why it matters when evaluating a company's earnings distribution and shareholder value.

Understanding Basic Earnings per Share

Imagine you're at a bakery, and the baker decides to distribute the earnings among the customers based on the number of pastries they bought. Basic Earnings per Share (BEPS) works in a similar way, quantifying the earnings available for distribution to common shareholders for each outstanding common share. It does so by dividing the earnings available to common shareholders by the weighted average number of common shares outstanding during a given period.

BEPS = (Earnings Available to Common Shareholders) / (Weighted Average Number of Common Shares Outstanding)

Interpretation of Basic Earnings per Share

To understand the significance of BEPS, let's imagine a garden where different plants represent different companies. In this garden, the taller the plant, the more profit it generates per share. Similarly, a higher BEPS indicates that the company is like a tall, flourishing plant, generating more profit per share. This reflects stronger earnings potential and the possibility of increasing shareholder value. On the other hand, a lower BEPS suggests a smaller plant, indicating lower profitability per share.

Calculation of Basic Earnings per Share

Calculating BEPS is akin to solving a puzzle with two main pieces: the numerator and the denominator.

Numerator

Think of the numerator as a treasure chest that holds the earnings available to common shareholders. To unlock this chest, we deduct any preferred stock dividends, whether declared or cumulative, from the net income. What remains represents the portion of the company's earnings that is allocated to common shareholders.

Denominator

The denominator can be likened to a scale that weighs the importance of each share. It measures the weighted average number of common shares outstanding during the period. This average takes into account the number of months each share was outstanding, creating a balanced assessment. Sometimes, it may even consider the daily or weekly weight of each share.

Diluted Earnings per Share

Picture a cup of coffee with a drop of milk in it. Diluted Earnings per Share (DEPS) is similar to that coffee. It is computed for companies with capital structures that include options or convertible securities that could potentially dilute EPS upon conversion. These securities, also known as common stock equivalents (CSEs), are like drops of milk in the coffee. They include convertible debt, convertible preferred stock, warrants, and options. DEPS adjusts the numerator and denominator to reflect the dilutive impact of these securities, just as the milk dilutes the coffee flavor.

Weaknesses of EPS Calculation

Remember that analyzing BEPS has its caveats. It's like observing a landscape painting—while it provides a beautiful view, it might not capture every detail. EPS calculation can be influenced by a firm's dividend and financing policies. For example, firms with lower dividend payout ratios may exhibit higher EPS growth rates than those with higher payout ratios. It's essential to consider these factors when analyzing EPS trends and making comparisons between companies.

Example

Let's take a trip to the business world and consider the following information for Company XYZ:

Net Income: $1,000,000

Preferred Stock Dividends: $100,000

Weighted Average Number of Common Shares Outstanding: 100,000 shares

Now, let's calculate the Basic Earnings per Share (BEPS) for Company XYZ:

BEPS = ($1,000,000 - $100,000) / 100,000 shares
BEPS = $9.00 per share

In this example, Company XYZ has a BEPS of $9.00. Imagine each share as a delicious slice of pizza, and the $9.00 represents the profit from each slice. This means that for each outstanding common share, the company generated a profit of $9.00 that is available to be distributed to common shareholders.

Conclusion

Basic Earnings per Share (BEPS) acts as a compass guiding us through the vast landscape of a company's profitability on a per-share basis. By measuring the earnings available to common shareholders for each outstanding common share, it provides insights into the company's financial health. Like a compass, a higher BEPS indicates a stronger direction towards profitability, potentially increasing shareholder value. However, it's crucial to consider the dilutive impact of convertible securities when calculating Diluted Earnings per Share (DEPS). By carefully analyzing BEPS, investors and analysts can navigate the financial landscape, make informed decisions regarding investment, and unlock shareholder value.

This article takes inspiration from a lesson found in FIN 689 at Pace University.