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Unformatted text preview: EPS & NonGAAP Measures EPS & NonGAAP Measures Earnings per Share Earnings per Share
• Earnings per share (EPS) is considered one Earnings of the most important business indicators of • Indicates dollars earned per common share; Indicates earned
– does not report the dollars paid (or to be paid) per common share per • Calculations on both basic and diluted EPS Calculations basic diluted
– Basic EPS: Examine actual earnings and Basic actual number of shares outstanding actual – Diluted EPS: “What if” situation that takes into Diluted account of financial instruments such as options and convertible debt options How Important is Dilution? How Important is Dilution?
• Conversion or exercise of these instruments often Conversion decrease earnings per share decrease • Companies that increase earnings per share with dilution Companies are required to report only basic earnings per share are • Is reporting both measures important? http://www.abercrombie.ca/anf/index.html http://www.united.com/press/detail/0,6862,58579,00.html Earnings per Share
• Calculated as: Calculated Net Income less Preferred Dividends Weighted Average of Common Shares Outstanding
• Preferred Preferred dividends are those dividends that have been declared (non-cumulative) or in arrears (cumulative) for one year only one • If issue of additional shares is possible in the future, dilution can increase the number of shares outstanding (in this case both basic and diluted EPS are required) EPS Basic EPS Simple Capital Structure Basic EPS Simple Capital Structure
• If dividends on preferred shares are declared If and a net loss occurs, the preferred dividend net is added to the loss in calculating the loss per share share • In reporting earnings per share information, In dividends declared on preferred shares should be subtracted from income from continuing operations and from net income and from • In other words, dividends on preferred shares In should not be deducted in calculating EPS from discontinued operations and EPS from extraordinary items extraordinary EPS – The Numerator EPS – The Numerator
Example: Michael Limited • Net Income $3,000,000 • Shares
– 100,000 Class A preferred, cumulative shares, 100,000 dividend amount $4.00 per share dividend – 100,000 Class B preferred, non-cumulative 100,000 shares, dividend amount $3.00 per share shares, • No dividends declared or paid in the current No year year EPS – The Numerator EPS – The Numerator
Net Income $3,000,000 Amount attributable to Class A: 100,000 x $4.00 400,000 100,000 2,600,000 2,600,000 Amount attributable to Class B: 100,000 x $0.00 -0100,000 Income available to common shareholders $2,600,000 common $2,600,000
The Class B shares are non-cumulative, with no dividends The declared for the year no amount is deducted from Net Income declared EPS Simple Capital Structure EPS Simple Capital Structure
Net Income – Preferred Dividends Weighted Average # of Shares Outstanding • Number of shares issued is weighted by the Number period of time they were outstanding period • Each transaction (issue of shares, Each reacquisition of shares, retirement of shares) represents a weighting period represents EPS – The Denominator EPS – The Denominator
Date January 1 April 1 July 1 November 1 December 31 Share Changes Beginning balance 30,000 shares issued 39,000 shares purchased 60,000 shares issued Year end balance Shares Outstanding 90,000 120,000 81,000 141,000 141,000 EPS – The Denominator EPS – The Denominator
Dates Outstanding Shares Outstanding Fraction Weighted Shares Portion of Year Outstanding Jan. 1st to April 1st April 1st to July 1st July 1st to Nov 1st Nov 1st to Dec 31st 90,000 120,000 81,000 141,000 3/12 3/12 4/12 2/12 Weighted Shares 22,500 30,000 27,000 23,500 103,000 Weighted Average Shares Outstanding EPS – The Denominator EPS – The Denominator
Net Income – Preferred Dividends Weighted Average # of Shares Outstanding • Stock splits and stock dividends require Stock restatement of the outstanding number of shares restatement from the beginning of the year beginning of
– Because there has been no change in the Because company’s assets, or in the shareholders’ total investment investment – By restating the number, valid comparisons of By earnings per share can be made between periods before and after the stock split or stock dividend before EPS – The Denominator
• A final note (CICA Handbook, Section 3500)
– If there is a stock split or stock dividend after the If year end but before the publication of the financial statements financial statements • The weighted average number of shares The outstanding must be restated outstanding • This applies to the current year, as well as This previous years if comparative statements are issued issued EPS – The Denominator EPS – The Denominator
Given – Baiye Limited: January 1: 100,000 shares outstanding March 1: Issued 20,000 shares March Issued June 1: 50% Stock dividend (60,000 June additional shares issued) additional November 1: Issued 30,000 shares November Issued December 31: Ending Balance = 210,000 Ending shares outstanding shares EPS – The Denominator EPS – The Denominator
Dates O/ S Jan-Mar Mar-Jun Jun-Nov Nov-Dec Shares O/S 100,000 120,000 180,000 210,000 Restatement Fraction Weighted of Year Shares X 1.50 X X 1.50 X X X 2/12 = 3/12 = 5/12 = 2/12 = 25,000 45,000 75,000 35,000 180,000 Weighted average shares outstanding Class Exercise Class Exercise
• Karen Ltd. had 42,000 shares outstanding on Karen January 1, 2008 January • March 1, 2008: Issued 20,000 shares • July 1, 2008: Re-purchase 10,000 shares • October 1, 2008: Stock dividend of 10% October declared and issued declared
– What is the weighted average number of What shares outstanding? shares Class Exercise (Continued) Class Exercise (Continued)
Event Dates Outstanding Shares Outstanding Restatement 1.1 1.1 1.1 Fraction of Year 2/12 4/12 6/12 Weighted Shares 7,700 22,733 28,600 59,033 Beginning balance Jan. 1–March 1 42,000 Issued shares March 1–July 1 62,000 Reacquired shares July 1–Dec. 31 52,000 Weighted average number of shares outstanding Class Exercise (Continued) Class Exercise (Continued)
• What if the company declared a 3-for-1 stock split What instead of 10% stock dividend? instead Event Dates Outstanding Shares Outstanding Restatement 3 3 3 Fraction of Year 2/12 4/12 6/12 Weighted Shares 21,000 62,000 78,000 161,000 Beginning balance Jan. 1–March 1 42,000 Issued shares March 1–July 1 62,000 Reacquired shares July 1–Dec. 31 52,000 Weighted average number of shares outstanding Class Exercise (Continued) Class Exercise (Continued)
• What if the company declared a 1-for-2 reverse stock What split instead of 10% stock dividend? split
Event Dates Outstanding Shares Outstanding Restatement .5 .5 .5 Fraction of Year 2/12 4/12 6/12 Weighted Shares 3,500 10,333 13,000 26,833 Beginning balance Jan. 1–March 1 42,000 Issued shares March 1–July 1 62,000 Reacquired shares July 1–Dec. 31 52,000 Weighted average number of shares outstanding NonGAAP Performance Measures NonGAAP Performance Measures
• Despite the prominence of EPS, many Despite companies report alternative non-GAAP performance measures performance • Some examples:
– – – EBITDA Pro-forma (“street”) earnings Funds from operations (FFO) Pros and Cons of NonGAAP Measures Pros and Cons of NonGAAP Measures
– Exclude unusual items that do not represent Exclude the ‘core’ earnings of companies the – Provide a more persistent, higher quality Provide measure measure • Cons:
– Non-GAAP and un-audited, hence subject to Non-GAAP more manipulation more – Usually no standard definition (except FFO) How to Calculate NonGAAP How to Calculate NonGAAP Measures?
• Adjusted net income • What are the adjustments?
– Depends, mainly non-recurring items
• • • • Unusual loss/ gains One-time items Extraordinary items Adjustments How important are the Adjustments? How important are the Adjustments?
• Research in Motion
– – – Net Loss 2005 Q4: 2.6 millions Net 2.6 Adjusted net income: 140 millions Reason?
• RIM excludes from adjusted net income a nasty RIM litigation patent-infringement settlement! litigation EBITDA EBITDA
• Usually defined as net income before interest and Usually income tax expenses, and depreciation and amortization income
– Typical adjustments also include discontinued operations Typical and extraordinary items and – Other adjustments may include non-cash impairment Other charges, non-cash stock compensation expenses, and other non-cash income/ expenses other http://www.broadwing.com/bwngcorp/pages/ebitda.html Pro Forma Earnings Pro Forma Earnings
• Similar to EBITDA • Reported extensively by high tech firms
– Exclude amortization of intangible assets • Some examples: Pro Forma Cisco HP Jupiter Magma SCI 2004 Oct 2004 Oct 2004 Sept 2004 Sept 2004 Oct 1.5B 1.5B 73.5M 7.7M 41.8M GAAP 1.4B 1.3B 48.8M 0.3M 11.5M Concerns on NonGAAP Measures Concerns on NonGAAP Measures
• Non-GAAP earnings can be very different from GAAP Non-GAAP earnings earnings • The differences can be attributed to managerial The manipulation manipulation
– Managers are motivated to manage the un-audited nonGAAP measures to provide a better financial picture – S&P called pro forma earnings as EBBS or “earnings S&P before the bad stuff” before Evidence of NonGAAP Measure Evidence of NonGAAP Measure Manipulation 1
• Non-GAAP earnings are almost always higher than Non-GAAP GAAP earnings (Ciccone) GAAP Evidence of NonGAAP Measure Evidence of NonGAAP Measure Manipulation 2
• Non-GAAP earnings are more positive for loss firms Evidence of NonGAAP Measure Evidence of NonGAAP Measure Manipulation 3
• Non-GAAP earnings are less volatile when GAAP Non-GAAP earnings volatility is high earnings Safeguards on NonGAAP Measures Safeguards on NonGAAP Measures
• How to increase credibility of such numbers?
– – – Capital market governance Government regulation Industry guidance Capital Market Governance Capital Market Governance
• The example shows Cisco and HP have The similar pro forma and GAAP earnings similar • Governance mechanisms:
– – – – – – Larger firms Better corporate governance More matured firms Higher analyst following Better credit ratings Investor sophistication Government Regulations Government Regulations
• Regulation G (March 28, 2003):
– Presentation of the most directly comparable Presentation GAAP financial measure GAAP – Quantitative reconciliation of the non-GAAP Quantitative financial measure to the most directly comparable GAAP financial measure comparable – Declaration on no material misstatements or Declaration omissions that would make the presentation of the non-GAAP measure misleading the Industry Guidance Industry Guidance
• The Real Estate Investment Trust Industry The (REIT) has specific guidelines and recommendations for reporting Funds from Operations (FFO) Operations • Hence, firms may get scrutinized if deviate Hence, from the recommended definition by NAREIT from • FFO = net income adjusted for depreciation FFO for real estate assets (and associated gains real and losses on disposal), asset write-downs, discontinued operations, extraordinary items and cumulative effect of accounting changes and FFO Reconciliation Example FFO Reconciliation Example Exercise: FFO Reconciliation Exercise: FFO Reconciliation
• • • • • Depreciation of real estate: $400,000 Asset write-downs: $20,000 Loss on disposal of real estate: $25,000 Income from discontinued operations: $18,000 Net income: $580,000 • Prepare a reconciliation schedule of FFO Prepare Exercise: FFO Reconciliation Exercise: FFO Reconciliation
Net Income Depreciation of real estate Asset write-downs Loss on disposal of real estate Income from discontinued operations FFO $580,000 400,000 20,000 25,000 (18,000) 1,007,000 Caveat on FFO Caveat on FFO
• The required reconciliation by Regulation G The and the standard definition of FFO can help establish credibility on non-GAAP reporting establish • However:
– The reporting of non-GAAP measures remains The voluntary voluntary
• Firms only report when it is more beneficial to Firms do so (e.g., report FFO when difference of FFO and net income is large) and – FFO is REIT industry specific
• May not be applicable to other industries How Effective are the Safeguards? How Effective are the Safeguards?
• Han (2006) shows sophisticated investors Han reduce the likelihood of firms reporting pro forma forma • McVay et al. (2008) show that pro forma McVay exclusions are of higher quality following Regulation G Regulation • Tsang and Fortin (2008) show that REIT Tsang continues reporting FFO following Regulation G and the FFO is of higher quality and ...
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