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2.2. Diluted EPS

For many companies, the Basic EPS is all that is required to be presented. But, other companies must report an additional Diluted EPS number. The Diluted EPS is applicable to companies that have more complex capital structures. Examples include companies that have issued stock options and warrants that entitle their holders to buy additional shares of common stock from the company, and convertible bonds and preferred stocks that are potentially to be exchanged for common shares. These financial instruments represent the possibility that more shares of common stock will be issued and are said to be potentially "dilutive" to the existing common shareholders.

Accounting rules dictate that companies with dilutive securities take the potential effect of dilution into consideration in calculating the auxiliary Diluted EPS number. When you see a company that discloses Diluted EPS, it means they have done a series of (rather complex) calculations based on assumptions that dilutive securities are converted into common stock. The hypothetical calculations are quite imaginative; even going so far as to provide guidelines about how money generated from assumed exercises of options and warrants is assumed to be "reinvested" by the company. There is plenty of room to quibble over the merits of the assumptions, but the key point is that Diluted EPS provides existing shareholders a measure of how the company's income is potentially to be shared with other interests. Dilutive effects should never be ignored in investment decision-making!

2.3. Subdividing APS Amounts

You now know that public companies are required to report EPS information, and you earlier learned that companies must present a fully developed income statement that segregates income from continuing operations from other components of income (e.g., discontinued operations, etc.). Putting these two facts together, you might assume that EPS information should parallel the detailed information shown on the income statement. And, that assumption is correct. Earnings per share information must be subdivided to reveal per share data about income from continuing operations, discontinued operations, extraordinary items, and net income.

2.4. Price Earnings Ratio

Financial analysts often incorporate reported EPS information into the calculation of a popular ratio - the price/earnings ratio (P/E). This is simply the stock price per share divided by the EPS:

Price Earnings Ratio = Market Price Per Share/Earnings Per Share

For example, a stock selling at $15 per share with $1 of EPS would have a P/E of 15. Other companies may have a P/E of 5 or 25. Why would different companies have different P/E ratios? Wouldn't investors always be drawn to companies that have the lowest ratios since they may represent the best earnings generation per dollar of required investment? The answers to these questions are complex. Remember that the "E" in P/E is past earnings and does not reflect the future. New companies may have a bright future, even if current earnings are not great; investors are sometimes willing to pay a premium. Other companies may have great current earnings, but no room to grow; investors will not pay as much for these. And, don't forget that some companies hold valuable non-income producing assets; investors sometimes pay for such embedded values even if they are not presently generating an income stream. Suffice it to say, there are many reasons that P/E ratios differ among companies.

A related ratio that is gaining popularity is the "PEG" ratio. This is the P/E ratio divided by the company's "growth" rate. For example, a company with a P/E of 20 that is experiencing average annual increases in income of 20% would have a PEG of 1. If the same company instead had annual earnings increases of 10%, then the PEG would be 2. As a rule of thumb, the lower the PEG number, the more attractive the investment appears. Use this ratio with extreme care as growth rates are very susceptible to sudden changes; high growth rates are hard to sustain and many a high flying company has seen a sudden change in their fortune.

 
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