More of this Feature • Introduction • Income Statement • Revenue / sales • Cost of Goods Sold • Gross profit • Gross margin • The first three lines • Operating Expenses • R&D Expense • SG&A Expense • Goodwill Charges • Extraordinary Events • Accounting for extraordinary events • Oper. income/margin • Interest income and expense • Interest coverage ratio • Depreciation expense • Accum. Depreciation • Straight-line Method • Accelerated and Sum of the Years' Digits Method • Dbl Declining Balance • Comparing Depr. Mths • EBITDA • Income taxes • Minority Interests - cost, equity, and consolidated methods • Unreported earnings • Continuing operations • Accounting changes • Preferred dividends • Net income applicable to common shares • Net profit margin • Basic vs. Diluted EPS • Hiding share dilution • Share repurchases • Return on Equity- ROE • Asset turnover • Return on Assets- ROA • Projecting earnings • Formulas & Calculations • Putting it together • Segment 2

Related Resources • Investing Lesson 1 • Investing Lesson 2 • Investing Lesson 3 • More Lessons

From Other Guides • Diluted Earnings Per Share (Diluted EPS) • Basic Earnings Per Share (Basic EPS)

Elsewhere on the Web • Diluted EPS • The Different Types of Earnings Per Share- Diluted EPS and Basic EPS • Stock Basic Tutorial, Including Basic and Diluted EPS - Earnings Per Share • Fully Diluted EPS from Continuing Operations

Cherry Pie: Basic vs. Diluted Earnings per Share
When you analyze a company, you have to do it on two levels, the “whole company” and the “per share”. If you decide ABC, Inc. is worth $5 billion as a whole, you should be able to break it down by simply dividing the $5 billion price tag by the number of shares outstanding. Unfortunately, it isn’t always that simple.

Think of each business you analyze as a cherry pie and each share of stock as a piece of that pie. All of the company’s assets, liabilities, and profits are represented by the pie as a whole. ABC’s pie is worth $5 billion. If the baker [management] slices the pie into 5 pieces, each piece would be worth $1 billion [$5 billion pie divided into 5 pieces = $1 billion per slice]. Obviously, any intelligent connoisseur of pastries would want to keep the baker from making too many slices so his or her piece was as big as possible. Likewise, an ambitious investor hungry for returns is going to want to keep the company from increasing the number of shares outstanding. Every new share management issues decreases the investor’s “piece” of the assets and profits a tiny bit. Over time, this can make a huge difference in how much the investor gets to eat.

“How can management increase the number of shares outstanding?” you may ask. There are four big knives [perhaps “cleavers” would be a more appropriate term] in any management’s drawer that can be used to add increase the number of shares outstanding: stock options, warrants, convertible preferred stock, and secondary equity offerings [all sound more complicated than they are]. Stock options are a form of compensation that management often gives to executives, managers, and in some cases, regular employees. These options give the holder the right to buy a certain number of shares by a specific date at a specific price. If the shares are “exercised” the company issues new stock. Likewise, the other three cleavers have the same affect – the potential to increase the number of shares outstanding.

This situation leaves Wall Street with the problem of how much to report for the earnings per share figure. In response, they came up with two sets of EPS numbers: basic EPS and diluted EPS. The basic figure is the total earnings per share based on the number of shares outstanding at the time. The diluted EPS figure reveals the earnings per-share a business would have made if all stock options, warrants, convertibles, etc. were invoked and the additional shares increased the total shares outstanding. The percentage of a company that is represented by these possible share dilutions is called “hang”.

Although ABC may have 5 shares outstanding today, it may actually have the potential for 15 shares outstanding during the next year. Valuation on a per-share basis should reflect the potential dilution to each share. Although it is unlikely all of the potential shares will be issued [the stock market may fall, meaning a lot of executives won’t exercise the stock options, for example], it is important that you value the business assuming all possible dilution that can take place will take place. This practiced conservatism can mean the difference between mediocre and spectacular returns on your investment.

Below is an excerpt from Intel’s 2001 income statement.
 

In 2000, the difference between Intel’s basic and diluted EPS amounted to around $0.06. If you consider the company has over 6.5 billion shares outstanding, you realize that dilution is taking more than $390 million in value from current investors and giving it to management and employees.

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