Cherry Pie: Basic vs. Diluted Earnings per Share
When you analyze a company, you have to do it on two levels, the “whole company” and the “per share”. If you decide ABC, Inc. is worth $5 billion as a whole, you should be able to break it down by simply dividing the $5 billion price tag by the number of shares outstanding. Unfortunately, it isn’t always that simple.
Think of each business you analyze as a cherry pie and each share of stock as a piece of that pie. All of the company’s assets, liabilities, and profits are represented by the pie as a whole. ABC’s pie is worth $5 billion. If the baker (management) slices the pie into 5 pieces, each piece would be worth $1 billion ($5 billion pie divided into 5 pieces = $1 billion per slice). Obviously, any intelligent connoisseur of pastries would want to keep the baker from making too many slices so his or her piece was as big as possible. Likewise, an ambitious investor hungry for returns is going to want to keep the company from increasing the number of shares outstanding. Every new share management issues decreases the investor’s “piece” of the assets and profits a tiny bit. Over time, this can make a huge difference in how much the investor gets to eat (in this case, take out in the form of cash dividends).
“How can management increase the number of shares outstanding?” you ask. There are four big knives (perhaps “cleavers” would be a more appropriate term) in any management’s drawer that can be used to increase the number of shares outstanding:
