How Are Earnings per Share Calculated?

B

Earnings per share (EPS) is a financial metric used to measure the profitability of a company and is an important indicator for investors. It represents the portion of a company's profit that is allocated to each outstanding share of common stock. To calculate EPS, the following formula is commonly used:

EPS = (Net Income - Preferred Dividends) / Weighted Average Number of Common Shares Outstanding

Let's break down the calculation in more detail:

1. Determine Net Income: The first step is to obtain the net income figure from the income statement of the company. Net income is the total revenue generated by the company after deducting all expenses, taxes, and interest.

2. Subtract Preferred Dividends: If the company has issued any preferred shares, the dividends paid to preferred shareholders need to be subtracted from the net income. Preferred dividends are the fixed amount of dividends that are paid to preferred shareholders before any dividends are distributed to common shareholders.

3. Determine Weighted Average Number of Common Shares Outstanding: The weighted average number of common shares outstanding accounts for any changes in the number of shares during the period being measured. This is important because a company may have issued or repurchased shares during the year, which can affect the EPS calculation. The weighted average is calculated by multiplying the number of shares outstanding during each period by the respective portion of the reporting period, and then summing these values.

4. Divide Net Income - Preferred Dividends by Weighted Average Number of Common Shares Outstanding: After obtaining the net income figure and subtracting preferred dividends, divide this value by the weighted average number of common shares outstanding. This will give you the earnings per share.

5. Interpret the Result: The final value obtained from the calculation represents the earnings generated by the company per share of common stock outstanding. It provides insights into the company's profitability and can be compared to previous periods or benchmarked against other companies in the same industry.

Now, let's analyze the answer options provided:

A. Use the income statement to determine earnings after taxes (net income) and divide by the previous period's earnings after taxes. Then subtract 1 from the previously calculated value: This answer is incorrect as it suggests dividing the current net income by the previous period's net income, which does not give an accurate representation of EPS.

B. Use the income statement to determine earnings after taxes (net income) and divide by the number of common shares outstanding: This answer is correct. It follows the correct formula by dividing the net income (after taxes) by the number of common shares outstanding to calculate EPS.

C. Use the income statement to determine earnings after taxes (net income) and divide by the number of common and preferred shares outstanding: This answer is incorrect as it includes preferred shares in the denominator, which is incorrect for calculating EPS. EPS is calculated using only the number of common shares outstanding.

D. Use the income statement to determine earnings after taxes (net income) and divide by the forecasted period's earnings after taxes. Then subtract 1 from the previously calculated value: This answer is incorrect as it suggests dividing the net income by the forecasted net income, which is not how EPS is calculated. EPS is based on actual earnings, not forecasts.

In conclusion, the correct answer is B. Use the income statement to determine earnings after taxes (net income) and divide by the number of common shares outstanding.