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EPS, or earnings per share, is one of the most important ratios in finance. The EPS figure indicates how efficiently the company's management is using its stockholders' money. If a firm has both common stock and preferred stock, you must calculate the preferred dividends before you can arrive at the correct EPS for common shares.
Preferred vs. Common Stock
Corporations issue two types of shares. Common stock entitles the owner to a vote in the annual shareholder meeting and a share of profits distributed to stockholders.
Preferred shareholders cannot vote in the annual meeting. However, they are entitled to a fixed annual dividend payment that does not depend on the firm's profitability.
Preferred shareholders are akin to creditors. Just as a bank cannot receive more money than it is owed, the preferred stockholders cannot receive more than the contractually fixed amount, no matter how much money the firm makes. The preferred dividend per preferred stock equals the stock's par value multiplied by its coupon rate.
EPS is calculated only for common stock. Common stockholders care a great deal about how much money the company is making, because the more it earns, the more they can get paid.
For common stockholders, EPS is a measurement of how much money the company is making per outstanding share after accounting for preferred dividends. But from the preferred stockholder's perspective, it makes no real difference whether the company can barely pay the preferred dividends or it whether is making enormous sums of money.
Few companies distribute all of their earnings as dividends. The board of directors usually decides to reinvest some of the earnings into the business, while distributing only a portion as dividends. EPS is nonetheless an excellent measure of how well the company is managed.
Outstanding vs. Treasury Stock
When calculating the total dividends payable to preferred stockholders, you must use the number of outstanding shares as opposed to the total number of shares issued. Companies often purchase some of their own common or preferred shares. These shares, referred to as treasury stock, are not entitled to dividends, because that would result in the company paying money to itself.
Only shares owned by investors, also known outstanding shares, are paid a dividend. The number of outstanding shares equals the number of shares issued minus treasury stock.
To calculate EPS, first find the cash owed to preferred stockholders. This figure equals number of preferred shares outstanding, multiplied by the dividend per preferred share.
Assume the firm issued 3 million preferred shares, of which it bought back 2 million over the years. The company also has 1 million ordinary shares and it made $10 million over the last year. Each share of preferred stock has a face value of $100 and a coupon rate of 7 percent. Each preferred share is therefore entitled to $7 in dividends.
Total expense for preferred dividends is $1 million (the number of outstanding shares) multiplied by $7 = $7 million. This is the preferred dividend figure you must use when calculating EPS. In this example, earnings per share equals $10 million minus $7 million, divided by 1 million. The resulting EPS is $3.
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