Page 83 - Finance for Non-Financial Managers

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Finance for Non-Financial Managers
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Earnings per share fully
tell how his or her owner-
diluted Common stock
ship participated in the
earnings per share calculat- General Motors stock can
ed as if all stock options and warrants company’s huge earnings,
were exercised and if all preferred just as effectively as the
stock and convertible bonds were investor who owns
converted.Also fully diluted earnings 100,000 shares of GM.
per share.
And all those reporters
and advisors have made
EPS one of the principal gauges of a company’s profit per-
formance, and thereby one of the principal indicators of the
stock’s possible price performance.
The only problem is that there’s no one number for EPS,
with the result that many companies routinely report two such
numbers: earnings per share and earnings per share fully dilut-
ed. Huh? Why two? Well, it seems that some company employ-
ees—and perhaps others—are holding options to buy some of

Dilution Can Be Hazardous
to Your Investment
Let’s suppose you bought 10,000 shares of XYZ stock and
there are 100 million shares outstanding (including yours). Now, sup-
pose the company reports net income of $100 million for last year.A
little quick arithmetic and we can figure out that’s $1 per share of
earnings for each of those 100 million shares outstanding. Now let’s
suppose that the price/earnings ratio is 20.That would make the likely
value of each of your shares $20 and your investment would be worth
$200,000. If you bought the stock for $18, you now have a $20,000
profit (on paper).
But wait! There are some stock option holders out there, who
could purchase 5 million shares of XYZ stock.They like the earnings
report as much as you do, so they all exercise their options right after
the report. Now there are 105 million shares outstanding, to divide up
that $100 million in income, so each share now has claim on only 95
cents of earnings, not $1.At the same P/E ratio of 20, your shares are
now worth $19 each, not $20. Because of the dilution, your profit
drops from $20,000 to $10,000—a drop of 50%.