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MACR/U3 Topic 2 Computation of impact on EPS and Market Price

Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company’s profitability. EPS is calculated as:

EPS = (Net Income – Dividends on Preferred Stock) / Average Outstanding Shares

How to Calculate ‘Earnings Per Share – EPS’

To calculate the EPS of a company, the balance sheet and income statement should be used to find the total number of shares outstanding, dividends on preferred stock (if any), and the net income or profit value. When calculating, it is more accurate to use a weighted average number of shares outstanding over the reporting term, because the number of shares outstanding can change over time. Any stock dividends or splits that occur must be reflected in the calculation of the weighted average number of shares outstanding. However, data sources sometimes simplify the calculation by using the number of shares outstanding at the end of a period.

Let’s calculate the EPS for a couple of companies for fiscal year ended 2016:

Company Earnings (Net Income) Preferred Dividends Weighted Shares Outstanding Basic EPS
Ford Motors Company $1.23 billion 0 3.97 billion $1.23/3.97 = $0.31
Wal-Mart Inc. $13.64 billion 0 3.1 billion $13.64/3.1 = $4.40
NVIDIA Corporation $1.67 billion 0 541 million $1.67/0.541 = $3.08
McDonald’s Corporation $4.69 billion 0 854 million $4.69/0.854 = $5.49

Basic vs. Diluted EPS

The formula used in the table above calculates the basic EPS of each of these select companies. Basic EPS does not factor in the dilutive effect of additional securities. When the capital structure of a company includes stock options, warrants, restricted stock units (RSU), etc. these investments, if exercised, could increase the total number of shares outstanding in the market. To better show the effects of additional securities on per share earnings, companies also report the diluted EPS, which expands on basic EPS by including convertible securities in the outstanding shares number. The diluted EPS is the worst-case scenario for the earnings per share if certain securities were converted to common stock.

For example, the total number of NVIDIA’s convertible instruments for the fiscal year ended 2016 is 108 million. If this number is added to its total shares outstanding, its diluted weighted average shares outstanding will be 541 million + 108 million = 649 million shares. The company’s diluted EPS is, therefore, $1.67 billion / 649 million = $2.57.

Importance of Earnings Per Share – EPS

Earnings per share (EPS) is generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings (P/E) valuation ratio, where the ‘E’ in P/E refers to EPS. By dividing a company’s share price by its earnings per share, an investor can understand the fair market value of a stock in terms of what the market is willing to pay based on a company’s current earnings.

The EPS is an important fundamental used in valuing a company because it breaks down a firm’s profits on a per share basis. This is especially important as the number of shares outstanding could change, and the total earnings of a company might not be a real measure of profitability for investors. If Ford’s total earnings were to increase in a subsequent year to $1.8 billion, this might seem like great news to an investor until they consider the fact that the company’s total shares outstanding increased to 4.5 billion. In this case, EPS would have only gone up to $0.40.

An important aspect of EPS that’s often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could generate the same EPS number, but one could do so with less equity (investment) – that company would be more efficient at using its capital to generate income and, all other things being equal, would be a “better” company. Investors also need to be aware of earnings manipulation that will affect the quality of the earnings number. It is important not to rely on any one financial measure, but to use it in conjunction with statement analysis and other measures.

Market Price

Impact cost is the cost that a buyer or seller of stocks incurs while executing a transaction due to the prevailing liquidity condition on the counter. In other words, it represents the cost of executing a transaction of a given security, with a specific predefined order size, at any given point in time. 

Description: It is a realistic measure of liquidity of the stock or security and is deemed to be closer to the true cost of execution faced by a trader in comparison to the bid-ask spread (difference between the best buy and the best sell orders). It is the percentage markup observed while buying or selling a desired quantity of shares with reference to its ideal price. 

The ideal price can be illustrated by an example. 

Suppose a buyer wants to purchase 3,000 shares of, say, ABC. If the best buy order for 1,000 shares is placed at Rs 237 and the best sell order for 1,500 shares is placed at Rs 239, the ideal price for the deal should be: 

(239+237)/2 = Rs 238 

At this price, one can expect the buyer to ideally get the desired quantity of ABC shares. 

Opera Snapshot_2018-04-23_193023_economictimes.indiatimes.com

But suppose that the buyer was able to buy 3,000 ABC shares at an average cost of Rs 239.67 (see the above table) 

Average cost: [(1500x 239) + (1000 x 240) + (500 x 241)]/3000 

Or (3,58,500+ 2,40,000+ 1,20,500)/3000 = 239.83 

The impact cost, therefore, would be 0.70 per cent. To find the impact cost, the formula is: 

(Actual cost – ideal cost)/ideal cost*100 (#) 

In our example, the ideal price is Rs 238, but the average acquisition price for that buyer is Rs 239.67. 

By formula (#), the impact cost should thus be: 

(239.67 – 238)/239.67*100 = 0.70 

This is a cost that the buyers incur due to lack of market liquidity. The importance of impact cost can be judged from the fact that it is one of the criteria to select a stock for inclusion in the NSE’s benchmark index Nifty50. 

For a stock to qualify for possible inclusion into Nifty50, it has to have traded at an average impact cost of 0.50 per cent or less during the last six months for 90 per cent of the observations for a basket size of Rs 2 crore. 

It must be note that impact cost does vary for different transaction sizes. It is dynamic in nature and depends on the outstanding orders. Lastly, a penal impact cost is applicable if a stock is not sufficiently liquid.

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