# 16.5: The Computation of Earnings per Share

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

1. Compute and explain return on equity.
2. Discuss the reasons that earnings per share (EPS) figures are so closely watched by investors.
3. Calculate basic EPS with or without the existence of preferred stock.
4. Explain the relevance of the P/E ratio.
5. Identify the informational benefit provided by diluted EPS.

Question: Throughout this textbook, various vital signs have been presented. They include ratios, numbers, percentages, and the like that are commonly studied by investors as an indication of current financial health and future prosperity. One common measure isreturn on equity (ROE). How does an interested party calculate the return on equity reported by a business?

Answer: Return on equity reflects the profitability of a company based on the size of the owners’ claim to net assets as shown primarily through contributed capital and retained earnings. It is simply the reported net income divided by average shareholders’ equity for the period.

return on equity = net income/average shareholders’ equity

For example, PPG Industries began 2008 with total shareholders’ equity of $4,151 million and ended that year with a balance of$3,333 million. For the year ended December 31, 2008, PPG reported net income of $538 million for a return on equity of 14.4 percent. average shareholders’ equity: ($4,151 million + $3,333 million)/2 =$3,742 million
return on equity: $538 million/$3,742 million = 14.4%

## Key Takeaway

Return on equity (ROE) is one percentage often computed by market analysts to help evaluate the profitability of a business. However, the reporting of earnings per share (EPS) draws a much greater circle of interest. Basic EPS must be reported by every publicly traded company for each year in which net income is reported. Basic EPS is the net income for the period divided by the weighted average number of shares of common stock outstanding. Because EPS is only determined for common stock, any preferred stock dividends must be removed from net income as a preliminary step in carrying out this computation. The resulting figure is viewed as having a major impact on the movement of the company’s stock price. The price-earnings (P/E) ratio even quantifies that effect. If a corporation also has items such as stock options or convertible bonds that can be turned into common stock, conversion could potentially have an adverse impact on EPS. Thus, where such contractual obligations are outstanding, diluted EPS must also be reported to help investors understand the possible impact of future conversions.

### Talking with a Real Investing Pro (Continued)

Following is a continuation of our interview with Kevin G. Burns.

Question: Investors in the United States seem to have an obsession about the reporting of earnings per share. Even slight movements in projected EPS figures can create significant swings in the market price of a company’s stock. Do you think there is an overemphasis on EPS in the public’s investing decisions? How closely do you pay attention to EPS figures that are reported by the businesses that you are following?

Kevin Burns: This is a very good question. By now students must realize that accounting is really all about estimates. Although investors would like accounting to be objectively exact, reporting such estimates really requires an awful lot of subjectivity. For example, for many years, General Electric would almost always report EPS a penny or two above market expectations. This was quarter after quarter like clockwork. It got to the point where if the company didn’t “beat” the estimates on the street by a penny or two, the market was disappointed. It is absurd to believe that this is meaningful. This is especially true when earnings can also be managed simply by delaying or speeding up a major transaction from one time period to another. So, yes, I believe that EPS, although important, is not the ultimate piece of information that some investors seem to think. I am much more concerned about asset values, growth prospects, and what a company does with the cash it is able to generate.

## Video Clip

(click to see video)

Unnamed Author talks about the five most important points in Chapter 16 “In a Set of Financial Statements, What Information Is Conveyed about Shareholders’ Equity?”.