When you analyze a company, you have to do it on two levels: the whole company and the per share. For example, 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 (i.e., 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 will be 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 reslicing of the pie can make a huge difference in how much the investor gets to eat.
“How can management increase the number of shares outstanding?” you may ask. There are four big cleavers in any management’s drawer that can be used to increase the number of shares outstanding: stock options, warrants, convertible preferred stock, and secondary equity offerings (all sound more complicated than they are). Stock options, of course, 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 effect—the potential to increase the number of shares outstanding.
This issue leaves Wall Street with the problem of how much to report for the earnings per share (EPS) figure. In response, it came up with two sets of EPS numbers: basic EPS and diluted EPS.
- The basic figure is the total earnings per share based on the number of shares outstanding at the time of reporting.
2. The diluted EPS figure reveals the earnings per share a business would have made if all stock options, warrants, convertibles, and so on were invoked and the additional shares added to the total shares outstanding.
Although company 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 (e.g., the stock market may fall, meaning a lot of executives won’t exercise their stock options), it is important that you value the business by assuming that 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.