Chartered Financial Analyst (CFA) Level 1 Practice Exam

How is Basic Earnings Per Share (EPS) calculated?

1. (Net Income - Preferred Dividends)/(Weighted Average of Ordinary Shares Outstanding)

2. Net Income / Total Shares Outstanding

3. (Net Income + Preferred Dividends) / Total Shares Outstanding

4. (Net Income - Preferred Dividends) / Total Equity

The correct answer is: (Net Income - Preferred Dividends)/(Weighted Average of Ordinary Shares Outstanding)

Basic Earnings Per Share (EPS) is calculated by taking the net income of a company and subtracting any preferred dividends, then dividing the result by the weighted average number of ordinary (common) shares outstanding during the period. This formula effectively reflects the earnings available to ordinary shareholders by accounting for the obligations to preferred shareholders first, ensuring that the earnings reported are exclusively attributable to common shareholders. The use of the weighted average of ordinary shares outstanding is crucial because the number of shares may change over the reporting period due to actions like issuing new shares, buybacks, or stock dividends. This approach provides a more accurate measure of the earnings allocated to each share of common stock. Other methods provided in the answer choices would lead to inaccuracies in reflecting the earnings available to common shareholders. For instance, using total shares outstanding does not account for the timing of shares issued or repurchased throughout the reporting period, resulting in a misleading EPS figure. Similarly, adding preferred dividends back to net income dilutes the clarity of the earnings specifically attributable to ordinary shareholders, which is why the first formula is the correct and widely accepted calculation for Basic EPS.