| Basic vs. Diluted Earnings per Share - Basic EPS - Diluted EPS | ||||||||||||||||
| Investing Lesson 4 - Analyzing an Income Statement | ||||||||||||||||
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Cherry Pie: Basic vs.
Diluted Earnings per Share 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. Next page > Hiding Share Dilution: Abercrombie and Fitch> << back, 28, 29, 30, 31, 32, 33, 34, 35, more >> |
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