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 (in this case, take out in the form of cash dividends).
“How can management increase the number of shares outstanding?” you ask. There are four big knives (perhaps “cleavers” would be a more appropriate term) in any management’s drawer that can be used to increase the number of shares outstanding:
- stock options,
- convertible preferred stock, and
- secondary equity offerings
All four of these 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 potential result – the possibility of increasing 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, the accountants created two sets of EPS numbers: Basic EPS and Diluted EPS.
The basic EPS 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 generated if all stock options, warrants, convertibles, and other potential sources of dilution that were currently exercisable were invoked and the additional shares printed resulting in an increase in 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.
At the bottom of the page 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. That is a huge amount of money.
This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.
Excerpt - 2001 Annual Report
|Earnings per share from continuing operations||2001||2000|