Calculating ratios aids in analyzing a corporation’s performance
Many people would like ownership in a successful business, even if the ownership is a small portion. Looking down at that certificate that states shared ownership in Microsoft, Intel, Pizza Hut, or Amtrak can put a person on a higher status level as well as swell the chest a little.
Unfortunately, not everyone can afford to purchase part ownership, that is, invest, in a business. Not everyone knows how to choose a business in which to invest. Those potential investors who do know how to choose which corporation’s shares to purchase do so by perusing the financial statements of the corporation of choice and calculating liquidity, activity, profitability, or coverage ratios.
The most widely-used ratio is a profitability ratio called earnings per share (EPS), which measures net income earned on each share of common stock. Another ratio used to judge the suitability for investment of a corporation is a coverage ratio called book value per share, which measures the amount each share would receive if the corporation was liquidated.
Contributed capital, earned capital, EPS reports different important facts
In a corporation, a major source of assets is stockholder’s equity. A person’s percentage of ownership in a corporation depends on the number of shares owned in relation to the total shares issued. Corporations sell their classes of stock separately in order to track the proceeds of each class and each lot, therefore, reporting contributed and earned capital separately facilitates accounting for stockholders’ equity.
Contributed capital reports the dollar amount of paid-in capital, that is, the amount of money investors paid for the shares. A little calculation will reveal the number shares corresponding to that dollar amount and the amount per share. Earned capital attests to the financial health of a corporation and to the competence and effectiveness of its managing staff, therefore, earned capital is more important to investors. However, if contributed capital and earned capital are reported as a lump sum, the number of stockholders, the competence, and the effectiveness of the managing staff cannot be ascertained. Neither can the EPS ratio or the book value per share ratio be calculated accurately.
SFAS 128 requires EPS, BEPS, and DEPS measurements
In February of 1997, the Financial Accounting Standards Board (FASB) declared Statement of Financial Accounting Standards No. 128 (SFAS 128), Earnings Per Share. SFAS 128 requires corporations to report two EPS calculations. One amount is basic earnings per share (BEPS) another amount is a diluted earnings per share (DEPS). BEPS measures the earnings available to stockholders without consideration of the potential dilution from other securities that could be exchanged for common stock. DEPS measures income available to common stockholders and all securities that have the potential to be exchanged for common stock. The purpose of presenting both basic and diluted EPS is to inform financial statement users of the worst case scenarios involving EPS.
The importance of the two calculations, BEPS and DEPS, depends on the industry of the corporation of choice. EPS has a major influence on the selling price of a corporation’s stock. A modest change in EPS could affect a stock-price change of 12% or 16%. In industries with complex capital structures a dilution could be close to four cents per share. Because of the influence of EPS on stock prices, DEPS is more important to investors than BEPS.
Stock options, convertible preferred stock, and convertible bonds dilute EPS
Industries with large dilution of EPS are the airline industry, title insurance, and computer programming services. Corporations in these industries tend to have employee stock options. Employee stock options contribute to a large dilution of EPS and this information would be important to investors.
In most cases, the difference between the BEPS and the DEPS is small, but an investor should take a look at the debt structure of a complex capital structure corporation. Convertible bonds and convertible preferred stock could dilute EPS if exchanged for common stock. The financial notes will explain the employee stock options and the convertible contingencies.
Comparing corporation to corporation
EPS is an excellent measure for evaluating a single corporation. Comparing one corporation to another can be better achieved by comparing the price/earnings (P/E) ratios. A P/E ratio is the market price per share divided by EPS and represents the value the market places on a share of stock relative to the corporation's earnings. P/E ratios can be found in the Wall Street Journal.
Sources
- Financial Accounting Standards Board (FASB) (1997, Feb). Statements of Financial Accounting Standards No. 128 Earnings Per Share. Accessed June 1, 2011.
- Jordan, C E, Clark, S J, & Smith, W. R. (July-August 2007). Should Earnings per share (EPS) be taught as a means of comparing intercompany performance? Journal of Education for Business, 82, 6. p.343(5). Accessed May 31, 2011, from General OneFile via Gale.
- Kieso, D.E., Weygandt, J.J., Warfield, T.D. (2007). Intermediate accounting (12th ed.). New York: Wiley.
- Slavin, N. & Yun, J. K. (2001, July/August). Earnings per share: A review of the new accounting standard. The Journal of Corporate Accounting & Finance, 12(5), 57. Accessed March 25, 2009, from ABI/INFORM Global database. (Document ID: 75198889).
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