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Investing for Beginners

By Joshua Kennon, About.com Guide

Basic vs. Diluted Earnings per Share - Basic EPS - Diluted EPSInvesting Lesson 4 - Analyzing an Income Statement

Cherry Pie: Basic vs. Diluted Earnings per Share

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 isnt 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 companys assets, liabilities, and

profits are represented by the pie as a whole. ABCs 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 investors 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 managements drawer that can be used to increase the number of shares outstanding:

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 exer cised 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 al l of the potential shares will be issued (the stock market may fall,

meaning a lot of executives wont 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 Intels 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 tak ing more than $390 million in value from

current investors and giving it to management and employees. That is a huge amount of money.

Next page > Hiding Share Dilution ... > Page

This page is part ofInvesting Lesson 4 - How to Read an Income Statement . To go back to the beginning, see the Table of Contents .

Table INTEL-1

Intel

Excerpt - 2001 Annual Report

Ea r n i n g s p e r s h a r e f r o m c o n t i n u i n g o p e r a t i o n s 2001 2000

Basic EPS $0.19 $1.57

Diluted EPS $0.19 $1.51

This About.com page has been optimized for print. To view this page in its original form, please visit: http://beginnersinvest.about.com/od/incomestatementanalysis/a/basic-eps-diluted-

eps.htm

1

stock options,

warrants,

convertible preferred stock, and

secondary equity offerings

2 3 4 5 6 7 8 9 10

11 12

Diluted earnings per share, or

diluted EPS as it is often called,

is a more accurate version of

how much profit is left for you,

the owner, for every share of

stock you have in a company.

Earnings Per Share (Basic EPS) vs. Diluted Earnings Per Share http://beginnersinvest.about.com/od/incomestatementanalysis/a/ba

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Links in this article:

http://beginnersinvest.about.com/od/dividendsdrips1/a/aa040904.htm1.

http://beginnersinvest.about.com/od/incomestatementanalysis/a/share-dilution.htm2.

http://beginnersinvest.about.com/od/incomestatementanalysis/a/preferred-stock-income-statement.htm3.

http://beginnersinvest.about.com/od/incomestatementanalysis/a/net-income-applicable-to-common.htm4.

http://beginnersinvest.about.com/od/incomestatementanalysis/a/net-profit-margin.htm5.

http://beginnersinvest.about.com/od/incomestatementanalysis/a/share-dilution.htm6.

http://beginnersinvest.about.com/od/incomestatementanalysis/a/share-repurchase-programs.htm7.

http://beginnersinvest.about.com/od/incomestatementanalysis/a/understanding-return-on-equity.htm8.

http://beginnersinvest.about.com/od/incomestatementanalysis/a/asset-turnover.htm9.

http://beginnersinvest.about.com/od/incomestatementanalysis/a/return-on-assets- roa-income-statement.htm10.

http://beginnersinvest.about.com/od/incomestatementanalysis/a/table-of-contents-lesson-4.htm11.http://beginnersinvest.about.com/od/incomestatementanalysis/a/table-of-contents-lesson-4.htm12.

Earnings Per Share (Basic EPS) vs. Diluted Earnings Per Share http://beginnersinvest.about.com/od/incomestatementanalysis/a/ba

25/08/2012