Wednesday, November 5, 2008

The Curious Effect of Falling Stock Prices on Diluted EPS

As I’ve watched companies report earnings for the quarter that ended September 30th, I’ve noticed a strange phenomenon – companies are getting help to their Diluted Earnings Per Share line from falling stock prices.  It’s no secret that the stock market has been brutal over the course of the past six months, and company equity values have taken a beating.  But there has been one small side benefit to the decline in stock prices.  Of course, companies won’t come out and tell you what it is.  You have to be a pretty savvy investor and know your way around a company’s financials in order to figure it out. 

Here’s how it works:  many companies have issued a large number of options over the last decade and have a large number of options that go into the diluted earnings per share calculation.  To grossly oversimplify things, the more options a company has outstanding and the deeper they are in the money, the greater the number of shares in the denominator for purposes of calculating diluted (as opposed to basic) earnings per share.  So far, so good, as long as the stock price moves in a smooth fashion.  However, when you get a steep drop in the stock price, many of a company’s options go under water.  When an option’s exercise price is above the fair market value of the stock, the options are excluded from the diluted earnings per share calculation, and they are anti-dilutive.  (This sounds to me suspiciously like anti-matter, but I don’t think accountants are that imaginative.) The result is that companies with large numbers of stock options and steep price drops in the stock price wind up with fewer fully diluted shares in their diluted EPS calculation and hence a higher diluted EPS number.  Good luck getting them to fess up to that however, they do their best to bury the calculations deep in the 10K or 10Q.

Sometimes the numbers can be startling.  A few years back Microsoft had 649 million shares excluded from the calculation of diluted EPS because they were anti-dilutive.  Talk about a big overhang on EPS if the stock price ever recovers.  More usually, the anti-dilutive effect is smaller, say one or two cents per share in each quarter.  The point here is two-fold: first, in Wall Street’s eyes, one or two pennies per share per quarter is a lot; when companies miss by that much, they get punished; and second, this is a non-operational benefit that companies are getting due to the bear market.  Companies are quick to tell you when non-operational issues hurt the EPS line, so why do they stay so quiet when it runs in their favor?

Finally, as long as I’m on my soapbox, where have all the highly paid Wall Street analysts been on this issue?  I have not seen a single analyst report that mentions this.  So here’s some advice to all my sell side friends – when diluted and basic EPS suddenly start looking the same where in previous years diluted was lower than basic, the company is probably getting some non-operational help from anti-dilutive options. Things aren’t as good as they seem.

Now, just like anti-matter coming into contact with matter, I will disappear.

1 comment:

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