Securities that can be converted to common stock
It is important to keep paid-in capital separate from earned capital (retained earnings) because they are two different forms of capital. For the investor, it is important to understand the differences between the two. Paid-in capital is the capital that the stockholders have paid into the business. Earned capital is the capital that has accumulated from the firm’s earnings (Kieso, Weygandt and Warfield, 2007). Thus, the latter is a measure of how much money the firm has made while the former is a measure of how much money the firm has raised.
It is important to keep these two forms of capital separate because they derive from two different activities. On the cash flow statement, for example, paid-in capital would be a financing cash flow while earned capital would be a combination of operating and investing flows. By maintaining a clear distinction between the two, the exact nature of the firm’s capital structure can better be determined. This allows for more accurate evaluation of the firm’s financial condition.
On the balance sheet, the different forms of assets, liabilities and equity are all kept separate. This facilities financial evaluation, and gives a more accurate portrayal of the company’s financial circumstances. The two major forms of equity represent two entirely different activities and two entirely different types of financing. For investors and other stakeholders, understanding how much of the company’s equity comes from its profits is important, perhaps more important than understanding how much money the company is able to raise on the capital markets.
2. For the investor, it is likely that earned capital is more important. To understand the primary reason for this, the objective of the investor must be understood. The simplest understanding of the objective of investors is that they want to earn a return on their investment. Paid-in capital is not representative in any way of return. It simply accounts for the money that has been put into the firm by the stockholders. Indeed, for the average investor any growth in paid-in capital would likely represent a dilution of the value his or her own equity holding.
Earned capital, on the other hand, derives from the firm’s earnings, net of any dividend payments. When a firm does not have earnings, it does not record earned capital. Therefore, earned capital is essentially the cumulative earnings of the firm that have been reinvested in the firm. For the investor, this is the more valuable of the two pieces of information. The firm’s earnings, when plowed back into the firm, represent an increase in the book value of the firm’s equity. This increase in the book value comes without an increase in the number of shares. Therefore, it represents an increase in the book value per share of the firm’s equity — an increase in the value of the investor’s stock. The more the firm’s equity grows without additional paid-in capital, the more valuable the firm’s stock is both in terms of book value and probably in terms of market value as well.
Therefore, the investor will want to track the growth in the value of the retained earnings or earned capital. The growth in this line item will reflect on the overall financial performance of the company, especially its profitability and the determination of management to plow earnings back into growth. For the investor, tracking the changes in earned capital allows for not only an assessment of the firm’s profitability but of management’s assessment of the firm’s future prospects. When management believes that reinvesting in the company will generate a higher rate of return than paying dividends to the shareholders, that indicates that management still believes the firm is on a growth trajectory. For the investor, it is important to know management’s belief in the company’s future prospects, as this will impact on the future growth rate not only in the company but in its profits and in the book value of its equity.
3. For any publicly-traded company, the earnings per share (EPS) number is one that investors carefully watch. The headline EPS number is typically the basic EPS, but on the income statement companies must report both the basic and diluted EPS. The basic EPS takes into account the net income (less preferred dividends) as the numerator and the weighted-average number of shares outstanding as the denominator. The diluted EPS number has the same numerator — net income — but a slightly different denominator. The denominator in the diluted EPS must take into account the affects of any potentially dilutive securities on the number of shares outstanding. Companies would typically “weight the shares by the fraction of the period they are outstanding” when making this calculation ((Kieso, Weygandt and Warfield, 2007) in a calculation of basic EPS, but in diluted EPS this calculation must factor any securities outstanding that can be converted to common stock.
There are a number of types of securities that can be converted to common stock, including convertible bonds, warrants, rights or employee stock options. The diluted earnings per share number, therefore, is a more accurate reflection of the EPS once all the outstanding common stock and securities that could become common stock are taken into account.
For the investor, diluted EPS is the more accurate and more useful number. Dilutive securities can reduce the earnings per share, and that in turn dilutes the book value of the earnings that are reinvested into the company. If there is a strong dilutive effect, the investor will actually lose as the value of the net income attributed to his or her shares is reduced.
Most companies that have complex capital structures will publish both a basic and a diluted EPS. While for the investor the diluted is more valuable information because it more accurately reflects the value of the earnings that will be added to the owner’s equity having both can be valuable. The difference between the basic and diluted EPS will reflect how many dilutive securities exist. Firms with very little difference in the value of the basic and diluted EPS do not have many dilutive securities. But other firms do, and this is something that the investor will want to be aware of when making the investment decision. The amount of dilutive securities outstanding directly impacts the present value of future cash flows, and therefore the fair value today of the company’s stock.
While the basic EPS remains the headline number, this is only because it is often similar to the diluted EPS, and because it is easier to understand. However, for the investor the more complete calculation is the diluted EPS because it includes all of the components of the basic EPS and then additional components that provide more information. Both EPS figures are valuable, but to choose between them an investor should be more concerned about the diluted EPS.
Kieso, D.E., Weygandt, J.J., & Warfield, T.D. (2007). Intermediate accounting, (12th ed.). Hoboken, NJ: John Wiley & Sons.
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