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 • Stock Basic Tutorial, Including Earnings Per Share

Finding Hidden Potential Dilution
According to accounting rules, companies don't include the possible share dilution from options that are "underwater". This occurs when an employee owns options to buy shares at a certain price, and due to a sudden drop in stock market value, the option is below the exercise price. If [and this is a big if], the stock does not rise over the exercise price, the option will expire worthless. On the other hand, if the stock advances to higher levels, these options will probably be exercised, increasing the number of shares outstanding, and dilution your percentage ownership in the business.

The problem with not including these underwater options in the diluted figures is that options normally have extended life [in some cases around 10 years]. In that time, it is very likely if not certain that some of those options will become valuable once the company's stock price rises.

Here's an example from Abercrombie & Fitch's 10K:

Options to purchase 5,630,000, 9,100,000 and 5,600,000 shares of Class A Common Stock were outstanding at year-end 2001, 2000 and 1999, respectively, but were not included in the computation of net income per diluted share because the options' exercise prices were greater than the average market price of the underlying shares.

As you analyze companies, you must keep your eye out for unusually large potential dilution. In the case of Abercrombie & Fitch, the management team has done a fantastic job over the past ten years and both I and my companies have owned shares and derivatives on the stock.

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