Earnings per share (EPS) represent a primary consideration for how much investors are willing to pay for a company's common stock. The EPS figure is also used to determine the price-to-earnings (PE) ratio, which is a widely used valuation tool. A corporation with preferred shares calculates its EPS by subtracting those dividends from net income divided by the average shares outstanding. Higher levels of preferred stock result in increased dividend obligations that reduce EPS, balanced against how well the business puts the money to use from the sale of preferred shares.
A company with quarterly income of $10 million and $500,000 in preferred stock dividends will report net earnings of $9.5 million. With 1 million shares outstanding, earnings per share will be $9.50. Corporations focus on EPS growth to make their common stock more attractive to investors and to give them greater flexibility in hiring, salary and investment decisions.
Companies adept at efficiently using their capital are typically more profitable and trade at a premium to their competition. If company A is built on $1,000,000 in equity and earns $100,00 per year, it is more attractive than Company B with a higher level of preferred stock but earnings of $90,000. An increased amount of preferred shares costs the company more in dividends, which leaves less cash available to be counted toward earnings per share. Investors parse balance sheets in part to determine earnings quality and the efficient use of capital.
Use of Funds
Companies generally have a clear plan for the use of funds gleaned from the sale of preferred stock, with the goal of increasing earnings per share. For example, if that stock sale yields the money to build a new plant, grow production capacity and increase EPS, the company would proceed. This option can be more palatable than borrowing money from a bank or issuing bonds, as preferred stock does not increase the amount of debt on a balance sheet.
Convertible Preferred Shares
Many companies that offer preferred shares to the public include a clause making them convertible into common shares at either the company's or shareholder's discretion. When these shares are converted, they no longer require dividends and that money can then be allocated to EPS on common shares. The downside is that more common shares are outstanding and earnings per share are diluted. Companies balance these considerations when deciding their financing options.