IAS 33 – Earnings per Share
What is earnings per share and why is it important?
Earnings per share (EPS) is a financial ratio that divides an entity’s accounting profit for a given period by its weighted average number of shares. The EPS figure is used widely, especially because it serves to calculate the “multiple” (price-to-earnings ratio) when valuing companies and making investment decisions. The “multiple” is a metric that reflects the payback period of the investment (assuming the company’s profit remains constant), and it is calculated by dividing the share price by the EPS amount. Although the multiple “mixes” accounting data (EPS) with market data (share price), which do not necessarily reflect the same assumptions and rules, there is no doubt that the multiple is an important model in company valuation and in assessing the attractiveness of investments. Empirical studies conducted over the years have shown that companies’ publication of EPS figures impacts share price.
How did EPS become part of financial reporting?
The topic of EPS entered the public consciousness—and the use of the multiple became common—in the late 1950s and early 1960s in the United States. Although EPS is a financial ratio (like other financial ratios) rather than a classic accounting amount like the other contents of the financial statements, due to its particular importance, securities regulators around the world decided to require public companies to include it in their financial statements. This requirement effectively turned EPS into an “accounting” figure like the other accounting amounts presented in the financial statements, and standard-setting bodies were required to establish principles for how public companies should compute EPS under accounting standards. The aim was to create uniformity in the computation and improve comparability between the performance of different reporting entities in the same reporting period and between the performance of the same reporting entity across different reporting periods. Over the years, these computation principles have undergone changes, amendments, and additions.
Why is prescribing a financial ratio under accounting standards controversial?
This process, driven by regulatory requirements applicable to public companies, creates the seemingly odd situation whereby a single financial ratio finds its place within the financial statements and is computed according to the principles of an accounting standard, unlike other financial ratios that are not included in the financial statements (such as return on equity). In general, it appears that a situation in which accounting standard-setters prescribe principles for calculating a financial ratio is not ideal by nature and perhaps would have been preferable not to occur.
What are the limitations of using EPS for comparison?
Using EPS data for decision-making requires investors to understand the principles used to compute it and the limitations inherent in its use. Thus, one cannot compare EPS data across different reporting entities, even within the same industry, because EPS is based on the number of shares issued by the reporting entity and, consequently, has no stand-alone value. For illustration, suppose there are two identical companies both in terms of the nature of their activities and their overall value, and each has profit of 100,000 for a given year. However, the companies have different numbers of shares outstanding: one has 100,000 shares and the other 10,000 shares. In that case, although the companies are identical economically, the first company’s EPS will be 1 (= 100,000/100,000) and the second company’s EPS will be 10 (= 100,000/10,000). Nevertheless, the use of the multiple eliminates this issue, since under these figures the price of each share of the second company will be ten times that of the first one.
What does IAS 33 require entities to present?
IAS 33 prescribes principles for calculating and presenting EPS. Under the Standard, EPS represents profit (loss) for the period attributable to the ordinary shareholders of the reporting entity, for each class of ordinary shares that have different rights to share in profit. Because the equity of reporting entities may include, in addition to shares, convertible instruments (such as warrants and convertible bonds) that may be converted into shares, or other potential ordinary shares, the Standard requires presenting EPS at two levels:
- Basic earnings per share – this figure is computed primarily based on the number of shares actually outstanding, without taking potential shares into account.
• Diluted earnings per share – this figure represents the worst-case scenario in terms of EPS; that is, in addition to the shares actually outstanding, it includes potential shares only if their inclusion would reduce a positive basic EPS (or increase a negative one).
How do basic EPS and diluted EPS differ in purpose?
Whereas basic EPS provides a purely performance-based figure — namely, the amount of profit “earned” per share during the period — diluted EPS provides a lower limit and using it to calculate the multiple allows an investor to gauge the maximum period over which the investment is expected to be recovered, if the company’s profit remains constant. In the capital markets diluted EPS is generally the figure used by analysts.
How is the weighted average number of shares determined?
The fundamental principle guiding the Standard in calculating EPS is that, in computing the number of shares (the denominator), one must weigh the number of shares that contributed to the profit during the period (the numerator) to achieve proper matching. Consequently, shares issued during the period are weighted from the date cash (or another asset) flowed in for them, proportionately for the period. For example, shares issued on the last day of the period will not enter the share count (denominator) at all, because the cash or other assets received did not contribute to the profit achieved during the period (numerator). The Standard also sets principles for how to include convertible securities, including how to include potential shares of investees, in calculating diluted EPS.
How does reliance on EPS vary across markets?
As a side note, users’ reliance on EPS varies from country to country. For example, the EPS of U.S. companies is frequently reviewed by analysts, so that if a company misses the analysts’ periodic EPS forecast — even by a single cent — its share price may fall significantly. In contrast, in other countries EPS figures might not be commonly used by users in valuing companies and assessing investment attractiveness.