Key takeaways:
- Learn to calculate and interpret Basic and Diluted EPS as per AS-20, including adjustments for preference dividends.
- Understand and compare key dividend policy theories: Walter, Gordon, and MM Hypothesis.
- Apply payout and retention ratios in practical scenarios for exam-oriented preparation.
Source: Pixabay
The concepts like Earnings Per Share (EPS) and Dividend Policy help you to analyze a company's profitability and its approach to rewarding shareholders and reinvesting for growth. Let's build your understanding step by step.
Earnings Per Share (EPS)
a. AS-20 EPS: Basic vs. Diluted EPS
AS-20 sets the framework for calculating and presenting EPS, a critical profitability indicator for shareholders. EPS measures how much profit is available to each equity share.
- Basic EPS shows the profit attributed to each ordinary share, assuming no potential equity shares exist.
- Diluted EPS reflects the profit per share if all convertible securities (like convertible debentures or stock options) were exercised and turned into equity shares. Diluted EPS is always equal to or lower than Basic EPS, providing a more conservative view.
Formulae:
| Type | Formula |
|---|---|
| Basic EPS | (Net Profit after Tax – Preference Dividend) / Weighted Average Number of Equity Shares |
| Diluted EPS | Adjusted Net Profit / (Weighted Average Number of Equity Shares + Potential Equity Shares from conversions) |
b. Example: Calculating EPS with Preference Dividend Adjustment
Example:
- Net Profit after Tax: ₹5,00,000
- Preference Dividend: ₹50,000
- Number of Equity Shares (beginning): 90,000
- New Shares issued mid-year: 30,000 (issued at the start of 6th month)
Step 1: Adjust Net Profit
Net Profit available to Equity Shareholders = ₹5,00,000 – ₹50,000 = ₹4,50,000
Step 2: Compute Weighted Average Number of Shares
- Shares outstanding for full year: 90,000 × 12/12 = 90,000
- Shares issued for 6 months: 30,000 × 6/12 = 15,000
- Total weighted shares = 90,000 + 15,000 = 1,05,000
Step 3: Calculate Basic EPS
Basic EPS = ₹4,50,000 / 1,05,000 = ₹4.29 per share
If potential shares (say, 10,000 from convertible debentures) are considered, add these to the denominator for Diluted EPS.
Diluted EPS = ₹4,50,000 / (1,05,000 + 10,000) = ₹4,50,000 / 1,15,000 = ₹3.91 per share
Dividend Policy
a. Dividend Policy: Relevance vs. Irrelevance Theories
Dividend policy dictates how much profit a firm returns to shareholders as dividends versus how much it retains for reinvestment. This decision impacts both shareholder satisfaction and the firm's growth prospects. Theories on dividend policy are broadly split into relevance and irrelevance camps.
| Theory | Relevance/Irrelevance | Key Points |
|---|---|---|
| Walter Model | Relevance | Dividend policy affects firm value; if the firm's return on investment (r) > cost of equity (ke), the firm should retain earnings. If r < ke, pay out dividends. |
| Gordon Model | Relevance | Value of the firm depends on dividend payout ratio; investors prefer certain dividends over uncertain future gains. |
| MM Hypothesis | Irrelevance | Dividend policy does not affect firm value in perfect markets; investors can create their own dividends (homemade dividends). |
b. Examples: Payout Ratio and Retention Ratio
Payout Ratio shows what portion of net earnings is distributed as dividends, while the Retention Ratio (or plowback ratio) indicates what is retained for growth.
- Payout Ratio = Dividend per Share / Earnings per Share
- Retention Ratio = 1 – Payout Ratio
Example: EPS = ₹8, Dividend per share = ₹2
- Payout Ratio = 2 / 8 = 0.25 or 25%
- Retention Ratio = 1 – 0.25 = 0.75 or 75%
A company with a high payout ratio signals stable, mature operations. A high retention ratio suggests the firm is reinvesting for growth—often the case with younger, expanding companies. But what happens if the market expects higher payouts and the company retains more? Consider the possible impact on share price and investor sentiment.
Exam Focus:
- Be ready to distinguish between Basic and Diluted EPS, and perform calculations involving weighted average shares and adjustments for preference dividends.
- Expect direct conceptual questions on dividend policy theories, especially contrasting relevance (Walter, Gordon) with irrelevance (MM Hypothesis) viewpoints.
- Practice calculating payout and retention ratios, interpreting what these indicate about a firm’s financial strategy.
Grasping these topics equips you to analyze profitability, assess management’s approach to shareholder returns, and interpret company growth prospects. Remember, every numerical calculation should be backed by a clear understanding of the underlying theory. Ask yourself: What does this ratio reveal about the company’s decisions?