Question

PB12.

LO 14.5You have some funds that you would like to invest and you are relying heavily on the EPS calculation to help you make your decision. Initially you are baffled about why preferred dividends are subtracted in the numerator and why a weighted average is used in the denominator, so you do some research and reflection and come to understand why. Your friend is interested in hearing about your thought process. How would you explain to your friend why it’s important to subtract preferred dividends and to use weighted averages?

PB13.

LO 14.5You are a consultant working with various companies that are considering incorporating and listing shares on a stock exchange. One of your clients asks you about the various acronyms she has been hearing in conjunction with financial analysis. Explain the following acronyms and how they measure different things but may complement each other: EPS (earnings per share), EBITDA (earnings before interest, taxes, depreciation, and amortization), and NOPAT (net operating profit after taxes).

Answer 1

PB12

EPS stands for Earnings Per Share which is a financial ratio calculated by dividing the amount of profit available to ordinary shareholders by the number of outstanding shares. It indicates how much profit the company makes for each shares and is used to estimate corporate value. If the EPS is higher, it indicates the company make more profit for each shares and the investors will be ready to pay more for such shares. It is easy for taking an investment decision simply by comparing the EPS ratio of different companies.

EPS is calculated as folllows:

EPS = (Net income - Preferred dividend) / Weigthed average shares outstanding

Preferred dividend is subtracted from the net income as the preferred stock is a different stock of shares and the amount of dividend is fixed irrespective of the amount of profit. Preference shareholders are not real owners of the company, they dont have any voting right or controlling power. So they are more of like a creditor. Equity or Common shareholders are the rela owners as they have voting right and they are the real risk takers. So prefernce dividend is excluded from the net income to arrive at the actual amount of profit avaialbel to ordinary shareholders.

To give an undistorted view of EPS, weighted average shares outstanding is used for calculation of EPS. It is easy to calculate the EPS just by using the toatl number of shares outstanding at the end of the year. But just assume if there is a buy back of shares at the end of the year, it will result into a high EPS which will not give a clear financial picture of the company. Or it may mislead the investors. To avoid such polishes weighted average shares outstanding is used. The number of shares outstanding may not be constant throughout the year due to shares buy back, conversion, new issues, etc.

Just for example

A compnay has 50000 ordinary shares at the beginning of the year. 40000 debentures were converted at the beginning of 7th month and 30000 new shares were issued at the beginning of 10th month. in this case weighted average shares can be calculated as follows:

	50000	6/12	25000
	90000	3/12	22500
	120000	3/12	30000
			77500

LO 14.5

EPS: Earnings Per Share

It is a crucial factor in assessing the company's profitability and is very imporant in calculating the stock price. It will help to measure even the past performance along with current profitability. Growing EPS indicates that the company is creating value for their investors.

EBITDA: Earnings Before Interest Tax Depreciation and Amortisation

It is calculated by adding back non cash items like depreciation and amortisation to Operatin profit. Actually it is a measure of operating performance. It allows us to focus on the results of operating decisions while excluding the effects of non-operating decisions and non-cash items. It is important while comparting the performance of different companies in the same industry because non-operating effects are unique to each industry.

NOPAT: Net Operating Profit After Taxes

It measures the efficiency of a highly geared companys operations. It is a company's potential cash earnings, it it had no debt portion in their capital. It is used to compare companies by remiving the impact the capital structure. With NOPAT we can compare two companies one with huge amount of debt and the other with no debt. It can be calculate as follows:

NOPAT = Income from operations x (1-tax rate)

All these ratios are used to take investment decisions.