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Hicorp, Inc.A Study of Earnings Per Share

Bloomington GroupJeff Attwood, Jean Baird, Susan Krieger,

Kent Miller, Terry Nichols, Randy Short

September 22, 2000

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Objectives

Earnings Per Share Terry Nichols– Definitions– Concept and Value– Calculations

Hicorp, Inc. Kent Miller– Case Study Analysis

Valuation, Criticisms and SummaryJeff Attwood

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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.

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Basic EPS

Net Income available for common shareholders Weighted average common shares outstanding

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Value of EPS

Assess Profitability– Current– Trends

Assist in Valuation

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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

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Diluted EPS

Net income available to common shareholders + Income effect of conversion Weighted average common shares outstanding + Dilutive potential common shares

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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”

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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

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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

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Example of Option Inclusion inDiluted EPS Market price of stock = $50

Common shares outstanding 1000

Exercise price of option = $40Option shares = 70In the money? YESAdditional Common Shares issued + 70Common shares outstanding 1070

Company buys back 56 shares with proceeds ($2800/$50) - 56Common shares outstanding 1014

Calculate diluted EPS with 1014 common shares outstanding

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Hicorp, Inc. – Calculations and Excel Worksheet

You can follow the Hicorp calculations on the Excel

spreadsheet located on the Virtual Classroom

Accounting website!

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Consider if . . .

Stock price averaged $95 in 4th Quarter 3rd 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

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Additional Considerationson Valuation

Price/Earnings Ratio

1 + Growth Rate in EarningsDesired Rate of Return by Equity Investors – Growth Rate in Earnings

Differing opinions on– Growth rate in earnings– Desired rate of return

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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) = 22 FAIR VALUED!

Investor B desires 15% return and forecasts 8% earnings growth Target P/E is 15.4 (1+.08)/(.15-.08) = 15.4 OVERVALUED!

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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

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Summary

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

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Questions??