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.
From a mathematical standpoint, it makes sense not to exclude the underwater options in the diluted earnings per share figure because they would be "anti-dilutive". That is, the price that the option holder paid would exceed the market value of the stock resulting in the company collecting more money than the shares were worth on the stock exchange. For the investor, you need to keep the level of underwater options in mind as you look at a potential investment because most options have extended lives, sometimes as long as 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. Thus, a company with a lot of underwater potential dilution could look cheap on paper but as the stock rises, find itself treading water for years as a result of an ever-increasing total of shares outstanding.
An Example of Underwater Options
I'm going to take one of my favorite investments, Abercrombie & Fitch. Both I and companies in which I have major investments have traded in the common stock and derivatives based upon the firm. I'm also going to reach nearly a decade into the past to illustrate my point instead of using current data and making you believe I have an opinion about a particular company one way or the other.
According to Abercrombie's past 10K filings with the Securities and Exchange Commission, "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. Anything more than 2% or 3% of shares should raise your eyebrows.
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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.
