A company, while computing its earnings per share (EPS) for a defined period, derives the result by dividing the profit generated with the total number of shares outstanding. Here, apart from its profit factor, its earnings can also be affected by the shares outstanding, which is subject to change over time due to multiple factors.
A company thus resorts to a weighted average shares calculation to accurately determine its earnings. It utilises this calculation to arrive at a total of outstanding shares not only at the end of a period but also throughout such duration.
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The number of shares in a company changes across a period due to factors like –
- Issue of shares
- Repurchase of shares
- Exercising employee stock option
- Existing shares retiring
- Stock split
- Warrant conversion
- Share buyback
While these can impact existing shareholding, it also results in a change in the outstanding shares of a company. Weighted average shares thus calculate share outstanding after factoring in all or any changes in the number of shares for a given period.
As already mentioned, it is an essential calculation a company must make when assessing their EPS, a key financial metric.
The formula for EPS calculation goes as –
EPS = (Net Income of the Company – Dividend Paid to Preference Shareholders) / Weighted Average Shares Outstanding for the Said Period
When calculating EPS, taking into consideration only the number of common shares outstanding at a period’s end would represent a skewed version of earnings, thus distorting a company’s outlook.
An instance of this can occur if a company undergoes a share buyback by the end of a financial year. Thus, if the EPS is calculated after simply adding such buyback, earnings so calculated will be much higher than the actual amount. It would thus represent a polished financial standing of a company. It is, therefore, essential to employ the weighted-average method of outstanding share calculation to arrive at an accurate number.
Before moving on to the weighted average number of shares outstanding calculation for a given period, it is essential to understand what a weighted average calculation comprises.
When making a weighted average calculation, one computes an average of several numbers by assigning a suitable weight to each unit number to make it an equivalent contributor to its total. The weight given to such number can either be a time proportionate or a proportionate of any variant that is causing such a change. Such weight must, however, be applicable and inherent to all changes.
In the case of weighted average shares calculation, a weight given to each share outstanding at a particular point during the period is time proportionate as the time factor is an inherent differentiator.
The weighted average shares can thus be calculated in the following few steps.
- Identify the count of shares outstanding at the beginning of a concerned period. Also, account all changes in common shares throughout such period.
- Compute and list down an updated total of all common shares after each change.
Here, you must note that any new share issue increases a total count while share repurchase leads to a total share count reduction. Similarly, you must take into account the effects of all changes and compute the total outstanding after each change accordingly.
- Assign a weight to each outstanding share count based on the time gap between one change and the next.
If calculated in days, the weight assigned would be – Total outstanding days / 365
If calculated in months, the weight assigned would be – Total outstanding month / 12
With this weighted average number of shares formula, the calculation of a weighted average of outstanding shares can be accurately done for EPS computation.
Below given are two instances and their calculations which would help you understand how to compute the outstanding weighted average shares.
- When new shares are issued once in a year
Company A had 1 lakh shares initially, and it issued 10,000 shares on 1st April.
The calculation of weighted average shares outstanding would thus be –
- In the first 3 months, company A had 1,00,000 shares, and 1,10,000 shares for such year’s remaining 9 months.
- Applying the time proportionate weight to each outstanding in terms of month, you get –
- 1,00,000 X 3/12 = 25,000
- 1,10,000 X 9/12 = 82,500
- Thus, the weighted average shares calculated at the end of the year stand at, 25,000 shares plus 82,500 shares, i.e., 1,07,500 shares.
- When in a given year, new shares are issued once; the company buys back its shares, debenture holders convert to equity share
Company B has a total outstanding of 5 lakh shares at the beginning of the financial year 2019-20. In the same year, its debenture holders converted their investments to equity shares for a count of 1 lakh shares as of 1st July 2019. Also, the company issued 50,000 new shares on 1st October 2019 and initiated share buyback on the same day for 20,000 shares.
The weighted average shares calculation is thus made below.
|Day of Change||Shares Outstanding||Weights||Weighted Average Share Calculation|
|1st April 2019||5,00,000||3/12 = 0.25||1,25,000|
|1st July 2019||6,00,000||6/12 = 0.50||3,00,000|
|1st October 2019||6,30,000||3/12 = 0.25||1,57,500|
Thus, the outstanding weighted average shares of a company for the given year is 5,82,500 shares.
Alongside this calculation, individuals must also know that while the share value computed is useful for basic EPS estimation, the calculation of weighted average shares for diluted EPS estimation involves intricate factoring in of variables that mostly include dilutive securities.
The computation of diluted shares outstanding via the weighted average method accounts for all the possible conversions. The diluted EPS so calculated thus always amounts to less than the value of basic EPS.