Dilutive Securities For a company having securities that are dilutive—meaning they could

Dilutive Securities For a company having securities that are dilutive—meaning they could

share in net income—there are two earnings per share amounts that are reported in financial statements. Beginning with fiscal years ending after December 15, 1997, companies must report both basic and diluted

FINANCIAL STATEMENT ANALYSIS

earnings per share. 7 This replaces the previous requirement of simple, primary, and fully diluted EPS. 8 Basic earnings per share are earnings (minus preferred dividends), divided by the average number of shares outstanding, which is the previ- ous standard’s simple earnings per share. Diluted earnings per share is earnings (minus preferred dividends), divided by the number of shares outstanding considering all dilutive securities (e.g., convertible debt, options), which is the previous standard’s fully diluted earnings per share. Companies that report earnings per share for any prior period must restate these amounts in terms of the new basic and diluted calcu- lations. The objective of the new reporting standard is to bring U.S. accounting in line with international accounting for earnings per share.

To see how the new earnings per share figures are calculated, con- sider American Express’s 2001 earnings per share. Net income for 2001 was $1,991 million. The average number of shares for the basic earn- ings per share figure was 464.2 million. Therefore,

$1,311 million Basic earnings per share = -------------------------------------- = $0.99 per share 1,324 million

As of 2001, American Express had the potential to issue 12 million additional shares that dilute earnings per share. 9 Adding the potential shares to the weighted average outstanding shares in the denominator,

$1,311 million Diluted earnings per share = -------------------------------------- = $0.98 per share

1,336 million

What difference does the new earnings per share reporting make? Prior to 1998, companies reported simple, primary, and fully diluted earnings per share. What is missing under the new standards is the pri- mary earnings per share amount that reflects some (but not all) dilution. Does it matter to the financial analyst which earnings per share data are presented? In one sense, it should not matter if we assume that analysts consider potential dilution in assessing a company’s earnings per share,

7 Statement of Financial Accounting Standards No. 128, “Earnings Per Share” (Stamford: Financial Accounting Standards Board, 1997).

8 Primary earnings per share is the earnings per share calculation that reflects the di- lutive effects of securities considered likely to be transformed into common stock,

such as convertible securities, options, and warrants. Fully diluted earnings per share are earnings per share that reflect the dilutive effects of all potentially dilutive secu- rities (for example, including options that are “out-of-the-money”).

9 Source: American Express 2001 annual report.

Earnings Analysis

focusing on the diluted earning per share. If analysts focus on primary earnings per share (that is, factoring in some, but not all dilution), that value would not be presented directly on financial statements and would have to be calculated using data on options and securities found in the notes to financial statement. Because many financial services have used primary earnings per share in their financial analyses, such as in the case of the price-earnings ratio (P/E) used by Bloomberg and Standard & Poor’s, among others, the new standard to report only basic and fully diluted earnings per share requires some adjustment of these analyses.

Does it make a difference in the reported figures? Consider the informa- tion provided by American Express that provides earnings stated according to the old standard and the new standard: 10

Basic earnings per share

Primary earnings per share

Diluted earnings per share

As you can see in the case of American Express, the primary earnings per share falls between the basic and diluted earning per share amounts.

The difference between the basic and diluted earnings per share over time can be seen for Microsoft Corporation in Exhibit 23.3. The differ- ence between the basic and diluted earnings per share varies over time, due to differences in the denominator of diluted earning per share—the number of dilutive securities outstanding.