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Hiding Share Dilution (Including Underwater Options)
Investing Lesson 4 - Analyzing an Income Statement
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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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