How Dividends on Preferred Stock Affect the Computation of EPS

Knowing how to calculate EPS will benefit every investor.

Knowing how to calculate EPS will benefit every investor.

Earnings per share (EPS) is a key figure in finance. It measures how much profit the company made for each common stock. A common stock is the most basic ownership unit in a corporation, and entitles the owner to receive a portion of the company's profits. Common stockholders keep a close eye on EPS, because the more the company earns, the more that can be paid as dividends. Preferred stockholders, on the other hand, are paid a fixed amount per stock every year, irrespective of the company's profits. Since preferred shareholders must be paid in full before common stockholders can receive any dividends, you must subtract preferred dividends from the company's net income to compute EPS for common stock.

Preferred vs Common Stock

Large corporations tend to issue two types of shares: common and preferred stock. Common stock entitles the owner to vote in the annual shareholder meeting, whereas the members of the board of directors are elected, and other major issues, such as mergers with other companies, are opened to shareholder vote. Common shareholders also receive a portion of the company's profits if the board decides to distribute a common stock dividend. Preferred stockholders cannot vote in the shareholder meeting and are entitled to a fixed annual payment for each preferred stock they hold. No matter how much money the company makes, preferred shareholders cannot receive more than this fixed sum.

Preferred Dividends

Each preferred stock carries a face value and a coupon rate. The face value is the original issue price of the stock, while the coupon rate is the percentage of the face value the stockholder will be paid every year. If, for example, the stock has a face value of $50 and a coupon rate of 8 percent, the holder of one such stock will be paid 8 percent of $50, or $4, every year. If the issuing company is making a single coupon payment every year, the stockholder will receive $4 once. In case of semi-annual coupon payments, the stockholder will be paid $2 per stock, twice a year.

Preferred Status

The reason preferred stocks are given that name is that they have priority over common stock. The company cannot legally pay a dividend to common shareholders until preferred stockholders are paid in full. In case of bankruptcy proceedings, too, preferred shareholders must receive the full face value of their shares before common stockholders can be paid any money from the asset sales. Therefore, you must determine the net amount owed to preferred stockholders and subtract this figure from net income. Only then will you arrive at the amount of profit that can legally be distributed to common stockholders.

Example

Assume the company earned $10 million during the last year and has 2 million common shares as well as 1 million preferred shares. Further assume that each preferred stock has a face value of $50 and a coupon rate of 8 percent. Let's calculate the EPS for common shares. Keep in mind that EPS is only relevant for common stockholders, since preferred stockholders already know what they will receive. Each preferred stock will be paid $4 per year. The total cash payable to all preferred stockholders is 1 million times $4, or $4 million. Subtracting this figure from the company's net earnings results in $6 million. Six million divided by 2 million, which is the number of common shares, results in an EPS of $3 for common stock.

 

About the Author

Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.

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