Page 68 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

54 The Complete Guide to Executive Compensation

• Earnings to price ratio This is earnings per share divided by stock price. Also
called capitalization ratio. In the example, this is 63¢ (Table 2-1) divided by $10, indi-
cating that the stock has a capitalization ratio of 0.06 to 1.

• Earnings per share (EPS) This is net income divided by the average total number
of shares outstanding equals earnings per share. In Table 2-1, this would be
$9,658,800 divided by 15,250,000, or 63¢. However, this excludes the diluted effect of
outstanding stock options. Factoring in stock equivalents (i.e., the net increase of the
exercise of all in-the-money stock options outstanding after buying back as many
shares as the option proceeds would enable) would result in diluted earnings per share.
In Table 2-1, this would be $9,658,800 divided by 16,250,000, or 59¢. Both figures are
shown in Table 2-1 for continuing and all operations. These can be compared current
year vs. previous year. In Table 2-1, the 63¢ would be an increase of 5¢ per share since
the previous year was 58¢. Recognize that this measurement does not discourage
decisions that may not be in the long-term interests of shareholders. Nonetheless, it
is probably the most frequently used measurement.

• Earnings before interest and taxes (EBIT) Also called operating income; many
argue that this definition makes the most sense in measuring executives as it includes
all expenses other than income taxes (over which executives have no control) and
interest charges (over which they may have some control). In Table 2-1, this is
$20,354,700.
• Earnings before interest, taxes, depreciation, and amortization (EBITDA)
This is gross margin less operating expenses or, stated another way, it is EBIT (oper-
ating income) with depreciation and amortization added back in. EBITDA is not usu-
ally found as a line item in many company annual reports, but it may be useful in
incentive plans if the board of directors believe management should not be held
accountable for borrowing and acquisitions decisions. However, many believe execu-
tives should be held accountable for achieving an income in excess of these amounts,
and therefore, it would be more logical to use EBIT than EBITDA. In Table 2-1,
EBITDA is $24,367,100.
• Economic profit (EP) This is what remains after the cost of capital is subtracted
from net operating profit after taxes (NOPAT). The cost of capital is the interest paid
on debt plus a return to the shareholders. The latter may be defined as dividends paid
or an expected return such as the risk-free rate of return on a government debt obliga-
tion plus a risk premium of, say, 6 percent. However, in the example, with NOPAT of
$20,110,400 (see NOPAT definition), interest expense of $3,845,700 (Table 2-1), and
dividends paid of $6,953,600 (Table 2-2), the economic profit is a gain of $9,311,100.
Alternatively, a cost of capital could be determined by determining the current short-
and long-term borrowing rates and what the investors look to receive beyond a risk-
free rate of return. Assume for illustration this is 10 percent. This might be multiplied
by capital consisting of net current currents. In other words, current assets minus cur-
rent liabilities, or $55,618,400 in the example ($79,301,500 less $23,683,100) plus
other assets ($251,696,400), or a total of $307,314,800. Applying the 10 percent rate to
this would result in a capital charge of $30,731,480. Subtracting this from NOPAT
would result in an economic loss of $10,621,080. Because of the equity element, this
measurement is most likely to be found only on the corporate level.