EARNINGS PER SHARE (EPS) - DILUTED

Where a company’s sources of finance includes either securities convertible into equity shares, or options and warrants which entitle holders to obtain equity shares, such financial instruments increase the likelihood that additional equity shares will be issued in the future. This possible increase in the number of shares is called potential dilution.

Case Study:

Suppose IStaR Ltd. has 30,000 equity shares outstanding in the market along with INR 100,000 of convertible debentures – that is, bonds that can be converted into equity shares. According to the terms of the debenture agreement, each INR 1,000 face value bond can be exchanged for 300 equity shares. If all the debentures were exchanged, bondholders would receive 30,000 new equity shares. The effect on current equity shareholders would be to dilute their claim to earnings from 100% - when they own all equity shares – to 50% - when they own only half of all outstanding shares.

Computed Basic EPS ignore this potential dilution of current shareholders’ ownership interest in the company. To recognize the increase in outstanding shares that would ensue from conversion or option exercise, IAS 19 / AS   (India) requires companies to compute Diluted EPS.

The diluted EPS is a conservative number of the earnings flow to each equity share. It’s conservative because it presumes the maximum possible new share creation – and thus minimum earnings flow to each equity share

The computation of Diluted EPS requires certain reasonable assumptions to be made. For example, once the bonds are converted into equity, the company need not make further bond interest payments.  Assumptions are also made for options or warrants exercise. When the holders of option or warrants exercise them, they receive equity shares; but at the same time, the company receives cash in an amount representing the exercised options or warrants. In the computation of the diluted EPS, this cash is assumed to be used to acquire the already outstanding equity shares in the market.

The Diluted EPS formula is:

To illustrate how the diluted EPS computation works, we will extend our IStaR example. Assume that on January 1, 2012 IStaR also had the following financial instruments outstanding:

• 1,000,000 of 5% convertible debenture bonds due in 15 years, which were sold at par (INR 1,000 per bond). Each INR 1,000 bond pays interest of 50 per year and is convertible into 10 equity shares
• Options to buy 20,000 shares of equity at INR 100 per share. These options were issued on February 9, 2011 and will expire on February 9, 2013

Let’s say the tax rate is 35% and IStaR shares sold for an average market price of INR 114 during 2012.

Each of these financial instruments is potentially dilutive and must be incorporated into the diluted EPS computation.

The convertible debentures are included in the dilutive EPS by assuming a conversion on the first day of the reporting period (here January 1, 2012). The after tax effect of interest payments on the debt is added back in the EPS numerator, and the additional shares that would be issued on conversion are added in the denominator. In the accounting terminology this is called as “if-converted” method.

As per this method, conversion of all the 1,000 bonds into 10,000 equity shares is presumed at the beginning of the year (January 1, 2012). No interest would have been paid on these debentures because all bonds are assumed to be converted as of January 1, 2012. This means that interest of 50,00 would not have been paid on presumptively converted bonds. With 35% tax rate, net income would increase by 32,500 (50,000 * [1-0.35]), and this amount is added to diluted EPS numerator.

The outstanding stock options will only affect the denominator of the diluted EPS computation. The adjustment reflects the difference between option exercise price (100 per equity share) and the average market price (114 per equity share) during the period. It is assumed that any proceeds received on exercise of the options (100 per share) are used to buy back already outstanding equity shares at the average market price for the period. This is called the treasury stock method.

Stock options are dilutive only when they are  in-the-money -  that is, when the average market price (114) exceeds the option price (100). Using the treasury stock method, we assume that 2,000,000 proceeds to the company from presumptive exercise price of the options ( 20,000 shares @ 100 per share) are used to repurchase previously issued equity shares at the 114 average market price. The cash from options is sufficient to acquire 17,544 shares (2,000,000 / 114 per share). Since 20,000 shares are presumed issued and 17,544 are presumed acquired, the difference 2,456 net new equity shares is added to dilutive EPS denominator.

Diluted EPS=( 1,257,331-70,000+32,500) / (173,333+10,000+2,456)

                                                                = INR 6.57 per share

Is EPS a meaningful number?

EPS data are published in the financial reports even though EPS suffers as a financial performance measure.

EPS ignores the amount of capital required to generate the reported earnings. This is easy to show with the following example that contrasts the 2013 financial performance of 2 companies:

	Company AB	Company PQ
Net income available to equity shareholders	1,000,000	1,000,000
Weighted average equity shares outstanding	100,000	100,000
Basic earnings per share (EPS)	INR 10	INR 10
Gross assets	20,000,000	30,000,000
Liabilities	10,000,000	10,000,000
Equity (Assets – Liabilities)	10,000,000	20,000,000
Return on equity (ROE)	10%	5%

Both Company AB and Company PQ report identical EPS of INR 10. But Company PQ needed twice as much equity capital and 50% more gross assets to attain the 1,000,000 net income. Even though both companies report the same level of net income and EPS, Company PQ has a return on equity of only 5%, while Company AB has 10%. It means that Company AB generates more earnings from the existing resources – that is, equity capital.

Because EPS ignore capital source, the problem arise when trying to interpret it. The narrow focus of EPS ratio clouds the comparison between two companies as well as year-on-year EPS changes for a single company. For example, even if year-on-year earnings level are the same, a company can improve its reported EPS by simply repurchasing some previously issued equity shares.

Earnings per share (EPS) is a popular and useful summary measure of a company’s profit performance. It tells you how much profit (or loss) each share of equity has earned after adjustments for potential dilution from options, warrants and convertibles are factored in.

But EPS has its limitations....

EARNINGS PER SHARE (EPS) - BASIC

EPS is simply profit amount divided by number of shares. Valuing a company as a whole is crucial during merger negotiations, buyouts or in similar arrangements – relatively rare events in the ongoing life of a company. For day-to-day valuations, many analysts prefer to focus on the value of single equity share. Here the earnings per share (EPS) computation helps to know how much of the company’s total earnings accrue to each share.

A simple capital structure exists when a company has no convertibles, no options or no warrants outstanding. The simple formula used to compute earnings per share (EPS) is:

To illustrate, IStaR Ltd. discloses the following information in the year 2012:

	January 1	December 31
Equity shares ( ` 1 face value)
160,000 shares issued and outstanding	160,000
200,000 shares issued and outstanding		200,000
Reserves	12,000,000	16,000,000
Retained earnings	1,100,000	1,800,000
7% Preference shares ( ` 100 face value)
10,000 shares issued and outstanding	1,000,000	1,000,000

The 40,000 additional equity shares were issued on September 1 and thus were outstanding for the last quarter of the year. The following factors explain the movement in retained earnings during the year 2012:

Retained earnings, January 1	1,100,000
Net income for the year	1,257,331
Preference dividend paid	(70,000)
Equity dividends	(487,331)
Retained earnings, December 31	1,800,000

The denominator of the basic EPS computation uses the weighted average number of equity shares outstanding. Since the additional shares were issued during the year, the weighted average number of outstanding shares is computed as follows:

  

Time	Shares outstanding (a)	Portion of the year (b)	Weighted average shares (c) = (a) * (b)
January 1 – August 31	160,000	2/3	106,667
September 1 – December 31	200,000	1/3	66,667
Weighted average outstanding shares			173,334

So now Basic EPS will be:

      = ` 6.85 per share

TRUE & FAIR: HOW MUCH?

While reading through the annual report of one of the listed company (TRF Ltd – A Tata Enterprise) in India my attention was drawn to a small paragraph in the ANNEXURE TO NOTICE - Explanatory Statements pursuant to Section 173(2) of the Companies Act, 1956. Although, the paragraph was concise but it provided enormous information on the company’s profitability.

Reasons for loss or inadequate profits:

The financial mis-statements were noticed in a particular division for earlier years. This was done by a group of officers who were discharged from the Company and Company has initiated necessary legal proceedings against them. A new team, who had taken charge of the division had reviewed the costs of the projects under execution and corrected the same where ever necessary. Consequently, the Company had to book losses in the division bringing down the overall profits of the Company.

This paragraph quite evidently mentions “mis-statements” by group of officers in a division. The company has initiated legal proceedings against them. Is it an indication by the company that money has been siphoned off by this group of officers or alternatively can we believe that the company has detected fraud in this division?

The highlights section in the annual report throws light on the profitability.

Consolidated PBT 2009- 10: 7,387 lakhs Rupees

Consolidated PBT: 2010- 11: 712 lakhs Rupees

Fall in profits by: 90.36%

The company has a functioning audit committee since 1997 which meets the representative of internal auditors (Big 4 company) and statutory auditors (another Big 4 company) regularly. To any one’s guess what is discussed regularly in such meeting with representatives of Big 4s.

The auditor’s report (Big 4 is a statutory auditor) states that:

Based on our audit and on consideration of the reports of other auditors on separate financial statements and on other financial information of the components, and to the best of our information and according to the explanations given to us, in our opinion the Consolidated Financial Statements give a true and fair view in conformity with the accounting principles generally accepted in India

Few questions which I do not know who will answer:

Did the auditors not detect the fraud when the company initiated legal action against a group of officers of a particular division?

Did the auditors not read the annual report of the company?

Did the auditors not find the drop in profitability compared to earlier year by 91% alarming and material?

What was the corporate governance from the audit committee’s perspective?

Who is answerable to the present shareholders of the company?

And finally;

HOW MUCH TRUE & FAIR WERE/ ARE THE FINANCIAL STATEMENTS AS OPINED BY THE AUDITORS?

For your reference and read as a case study of corporate governance link of the company annual report is attached.