The Diluted EPS and its other brothers!

At the end of 1997, a new rule went into effect, instituted by the Financial Accounting Standards Board (FASB). It required companies to report their quarterly earnings per share (EPS) in two ways: basic and diluted. However, there is much more to the different types of EPS in the balance sheet of different companies.

By definition, EPS is net income divided by the number of shares outstanding; however, both the numerator and denominator can change depending on how you define “earnings” and “shares outstanding”. So, the EPS will differ on two accounts:

• Shares Outstanding: Shares outstanding can be classified as either primary (primary EPS) or fully diluted (diluted EPS). Primary EPS is calculated using the number of shares that have been issued and held by investors. These are the shares that are currently in the market and can be traded. Diluted EPS entails a complex calculation that determines how many shares would be outstanding if all exercisable warrants, options, etc. were converted into shares at a point in time, generally the end of a quarter. We prefer diluted EPS because it is a more conservative number that calculates EPS as if all possible shares were issued and outstanding. Companies report both primary and diluted EPS, and the focus is generally on diluted EPS, but investors should not assume this is always the case. Sometimes, diluted and primary EPS are the same because the company does not have any “in-the-money” options, warrants or convertible bonds outstanding. Companies can discuss either, so investors need to be sure which is being used.
• Earnings: As has been evident in recent headlines, EPS can be whatever the company wants it to be, depending on assumptions and accounting policies. Corporate spin-doctors focus media attention on the number the company wants in the news, which may or may not be the EPS reported in documents filed with the Securities & Exchange Board of India (SEBI: http://www.sebi.gov.in). Based on a set of assumptions, a company can report a high EPS, which reduces the P/E multiple and makes the stock look undervalued. In context of the ‘earnings’ being used, there can be four types of EPS:
  • Reported EPS: We define reported EPS as the number derived from generally accepted accounting principles (GAAP), which are reported in SEBI filings. The company derives these earnings according to the accounting guidelines used. A company’s reported earnings can be distorted by GAAP. For example, a one-time gain from the sale of machinery or a subsidiary could be considered as operating income under GAAP and cause EPS to spike. Also, a company could classify a large lump of normal operating expenses as an “unusual charge” which can boost EPS because the “unusual charge” is excluded from calculations.
  • Ongoing EPS and/or Pro Forma EPS: This EPS is calculated based upon normalized or ongoing net income and excludes anything that is an unusual one-time event. The goal is to find the stream of earnings from core operations which can be used to forecast future EPS. This can mean excluding a large one-time gain from the sale of equipment as well as an unusual expense. Attempts to determine an EPS using this methodology is also called “pro forma” EPS. The words “pro forma” indicate that assumptions were used to derive whatever number is being discussed. Different from reported EPS, pro forma EPS generally excludes some expenses/income that were used in calculating reported earnings. For example, if a company sold a large division, it could, in reporting historical results, exclude the expenses and revenues associated with that unit. This allows for more of an “apples-to-apples” comparison. Another example of pro forma is a company choosing to exclude some expenses because management feels that the expenses are non-recurring and distort the company’s “true” earnings. Non-recurring expenses, however, seem to appear with increasing regularity these days. This raises questions as to whether management knows what it is doing or is trying to build a “rainy day fund” to smooth EPS.  
  • Headline EPS: The headline EPS is the EPS number that is highlighted in the company’s press release and picked up in the media. Sometimes it is the pro forma number, but it could also be an EPS number that has been calculated by the analyst/pundit that is discussing the company. Generally, soundbites do not provide enough information to determine which EPS number is being used.
  • Cash EPS: Cash EPS is operating cash flow (not the EBITDA) divided by diluted shares outstanding. Most analysts think cash EPS is more important than other EPS numbers because it is a “purer” number. Cash EPS is better because operating cash flow cannot be manipulated as easily as net income and represents real cash earned, calculated by including changes in key asset categories such as receivables and inventories.  

Some 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 such border-line deceptive practices as they are widespread and common occurrence.

(Sources:

http://www.investopedia.com/terms/c/casheps.asp

http://beginnersinvest.about.com/cs/investinglessons/l/blsharedilution.htm

http://www.fool.com/foolu/askfoolu/2002/askfoolu021113.htm

and Accounting Books)