Basic EPS is the amount of income available to common shareholders divided by the weighted average number of common shares outstanding over a period.
(Institute 187)
Institute, CFA. 2016 CFA Level I Volume 3 Financial Reporting and Analysis. CFA Institute, 07/2015. VitalBook file.
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Why do we use the weighted average number of shares? Aren’t dividends paid once a year so the amount paid in dividends is calculated based on the number of outstanding shares at the time of the payment?
This is something that helps make the numbers more comparable. (Say company had a fixed number of shares across time, vs. another company that had stock splits, stock dividends and the like).
So WASO helps rationalize (equalize) the denominator. The Numerator is the Earnings of the company.
Hello, can you please elaborate as to why EPS calculated using WASO is more appropriate as compared to EPS calculated taking the absoulte number of common shares outstanding at the time of preparing the financial statement?
As noted by CPK123, using the weighted average number of shares enhances comparability across numbers used by different firms.
Suppose you had two firms that had identical earnings for the same time period, but one firm issues a stock split a week before the end of the financial year.
If you used the absolute number of common shares to calculate EPS, it would be significantly lower for the firm that did the stock split, eventhough both firms pretty much had more or less the same financial performance for the period under consideration. Therefore, using the weighted average number of shares produces a more meaningful EPS for firms that is more “representative” of its underlying performance for the period under consideration.
This is not the best example since splits/dividends are assumed to have been outstanding for the entire year in WASO, therefore WASO = shares outstanding as of the balance sheet date if the only share transaction was a split or dividend. Otherwise, company A could earn $10 a share over the course of the year but do a 10:1 split on the last day of the year…if you don’t assume that transaction was outstanding for the full year, then you’d say EPS is still $10 a share and you have now have 10 shares which earned $10 each. That’d be very wrong.
An actual example would be that company A repurchased 50% of their shares outstanding on 12/31. This would create a difference between WASO and shares outstanding as of the year end date. As people have mentioned before, income is earned over the course of the year and it’d be distorting to use shares outstanding as of 12/31 in your EPS calc because, in fact, the company had many more shares outstanding (and equity deployed) for substantially all of the year.
Thanks for taking time out and answering the question guys…
This seems to be the most plausible explanation but still not completely convincing. Revenue is earned and expense is incurred throught the year and the net of each of this transaction is added together to arrive at new income…key point here being that the net of each of this can be added together…similarly shares can be issued or bought back throught the year. but for some reason instead of adding it we average it (as has been said apperantly it gives a fair picture of earnings per share)
Thanks guys! Any further explanation or correction is wolcome!!
For the calculation of the basic EPS, we use weighted average number of common shares OUTSTANDING as the denominator since not all shares are issued at the beginning of the accounting period. For instance, common shares issued on July 1st, were OUTSTANDING for 1/2 of the whole year. Also, earnings (numerator of Basic EPS) is not earned consistently throughout the year.