Tech Investors: Learn How to Compute Diluted EPS
Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If you have been around investing for any period of time, then you certainly know how to compute earnings per share. Simple, right? Net Income (the earnings part) divided by total outstanding shares (the share part). To get the often-used price to earnings ratio, you then take the stock’s price per share and divide it by the earnings per share. And presto! You have the company’s exact valuation.
Well, not really. You should also be aware of the diluted earnings per share, which is far more important to know when scouting for technology companies.
(Net Income – Preferred Dividends) + (Convertible Preferred Dividends) + (Convertible Debt Interest)(1- Tax Rate) /
(Weighted Average Shares) + (Shares from Conversion of Convertible Preferred Shares) + (Shares from Conversion of Convertible Debt) + (Shares Issuable from Stock Options)
The Chartered Financial Analyst (CFA) program covers this in depth, so it is an important concept to grasp. Now, what does this even mean? Good question.
Essentially, it tells analysts that preferred dividends (basically debt payments that are structured as equity), dividends from preferred stock shares that are convertible to common shares, and the interest on the debt (less the tax savings) are the real measure of the net income that will flow to owners as either equity or as dividends.
For the second part, you must calculate the total number of shares outstanding. First, take the average number of shares per year, then add in all the shares that were converted from preferred stock to common stock, the shares that were converted from debt to common stock, and the shares that can be issued from stock options.
To boil it down:
(Net income – preferred shareholders take of earnings) /
(Average shares outstanding for the year + preferred shares converted to common shares)
Now all of a sudden it looks far simpler, no? Here’s why it matters.
Facebook (NASDAQ: FB) and Zynga (NASDAQ: ZNGA) both have listed market caps of $39 billion (wow, Facebook has fallen a lot from its IPO) and $2.2 billion (so has Zynga). These market caps are verified based on Facebook’s 2.14 billion shares outstanding and Zynga’s 917 million shares outstanding.
But make sure you take a closer look. Remember that young tech companies often pay their employees in stock, and they acquire other firms with stock as well. When you add in Facebook’s stock options, restricted stock, and the new shares it will issue to pay for Instagram, Facebook now has 2.74 billion shares – and a $50 billion market cap. That’s more value, so it’s good, right? Not exactly.
At $39 billion in market cap, Facebook is trading at 30 times next year’s earnings forecast – a good valuation, but not extravagant. At $50 billion, Facebook trades at 38 times next year’s earnings. Now we are starting to get a little high, especially for a company that has fallen from a top of $45 into the mid- $17 range.
And Zynga is the same. Once you manipulate all the necessary data, Zynga comes out to have a $2.6 billion valuation, 18.18% higher than what is stated on Yahoo Finance. That number could really hurt investors.
Why does this happen? Because companies like Yahoo Finance and FactSet pull their numbers from firms’ most recent filings with the SEC. This number is on the front cover of the report, and the difference is usually negligible for most companies. However, for others it can be huge.
One other example is Sirius XM Radio (NASDAQ: SIRI), which is owned in part by Liberty Media (NASDAQ: STRZA). A Wall Street Journal article explains that Sirius has a $9.7 billion market cap and 3.8 billion shares outstanding. But what happens when Liberty Media exercises its security that converts into 2.6 billion more shares? Then what happens when you toss in restricted stock, options, and warrants? You get a radio company valued at $17.4 billion – that sounds good on the surface, but really shareholders are getting diluted.
Think of it this way – if you own $970 million of Sirius, then you control 10% of the firm. Say that all of the options were exercised at once and the firm jumped in value. Your stake would be diluted to a paltry 5.6%. Of course you still own the same number of shares and the same value, but your grip on the company has fallen significantly.
So what should an investor do with this information? Next time you look at a price to earnings ratio, ask yourself if the company is likely to pay employees in stock, or if it would make significant acquisitions in stock. If so, dig into the company’s outstanding restricted stock and option warrants. If it looks like you could be seriously diluted, give the stock a pass. And if you still like the company even after all of that, remember that you can still buy their debt or even their preferred stock.
To read more on diluted EPS, you might look at Investopedia.com’s resources for the CFA exam.
ChrisMarasco has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook. Motley Fool newsletter services recommend Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.