1 Hicorp, Inc. A Study of Earnings Per Share Bloomington Group Jeff Attwood, Jean Baird, Susan Krieger, Kent Miller, Terry Nichols, Randy Short September 22, 2000

2 Objectives Earnings Per Share Terry Nichols –Definitions –Concept and Value –Calculations Hicorp, Inc. Kent Miller –Case Study Analysis Valuation, Criticisms and Summary Jeff Attwood

3 Concept of Earnings per Share (EPS) What is Earnings per Share? –Net income available to common shareholders prior to receipt of common dividends and after dividends to preferred stockholders on a per share basis.

4 Basic EPS Net Income available for common shareholders Weighted average common shares outstanding

5 Value of EPS Assess Profitability –Current –Trends Assist in Valuation

6 Diluted Earnings per Share Required calculation by publicly held companies Shows a conservative (reduced) number for EPS Measures potential impact on basic EPS of following instruments: –Convertible preferred stock –Convertible debentures –Warrants –Options

7 Diluted EPS Net i ncome available to common shareholders + Income effect of conversion Weighted average common shares outstanding + Dilutive potential common shares

8 Diluted Earnings per Share What you need to know –Control number If positive... Calculate diluted EPS If negative... No calculation needed (Antidilutive) –Exercise price of instrument “In the money” “Out of the money”

9 Income Effect of Conversions Numerator Convertible bonds –Add back interest expense net of tax Convertible preferred stock –Add back preferred dividends Stock options –Add back related compensation expense net of tax

10 Dilutive Potential Common Shares Denominator Convertible Bonds and Convertible Preferred Stock –Add the amount of additional shares had the conversion taken place Stock Options and Warrants –Add the net additional shares added if proceeds were used to buy back shares at average market price

11 Example of Option Inclusion in Diluted EPS Market price of stock = $50 Common shares outstanding 1000 Exercise price of option = $40 Option shares = 70 In the money? YES Additional Common Shares issued+ 70 Common shares outstanding 1070 Company buys back 56 shares with proceeds ($2800/$50)- 56 Common shares outstanding1014 Calculate diluted EPS with 1014 common shares outstanding

12 Hicorp, Inc. – Calculations and Excel Worksheet You can follow the Hicorp calculations on the Excel spreadsheet located on the Virtual Classroom Accounting website!

13 Consider if... Stock price averaged $95 in 4 th Quarter 3 rd Quarter net income before changes was negative Extended useful life of equipment from 20 to 30 years Less profitable but purchased stock in open market

14 Additional Considerations on Valuation Price/Earnings Ratio 1 + Growth Rate in Earnings Desired Rate of Return by Equity Investors – Growth Rate in Earnings Differing opinions on –Growth rate in earnings –Desired rate of return

15 P/E Calculation Stock Price = $33 Diluted EPS =$1.50 P/E = 22 Overvalued? Fair Valued? Undervalued? Investor A desires 15% return and forecasts 10% earnings growth Target P/E is 22(1+.1)/(.15-.1) = 22FAIR VALUED! Investor B desires 15% return and forecasts 8% earnings growth Target P/E is 15.4(1+.08)/( ) = 15.4OVERVALUED!

16 Criticisms Amount of assets or capital required to generate EPS Comparing EPS –Different industries, different risks, different customers... Shares outstanding misrepresent capital in use –Companies may “manipulate the denominator” Smoothing effect of weighted average shares Exclusion of “out of the money” instruments Assumption of buy back on option/warrant exercise Use of control number Other earnings manipulations

17 Summary Earnings per share... –Helps assess profitability –Assists in valuation –Has its drawbacks!

18 Questions??