17.5. Track Profit into Earnings per Share

The bottom line for stock investors is not the bottom line. Shareowners' attention is riveted on the bottom-line profit figure, of course. But they can't stop their analysis at the bottom line. The value of a stock depends heavily on its earnings per share (EPS). So stockholders should track profit into EPS to check whether changes in EPS and profit are divergent. The risk is that the profit pie may be cut up into smaller pieces. Bottom-line profit may have increased 10 percent over last year, for example, but EPS may have increased less than 10 percent. How do you like that?

Here's an example with three different scenarios. A business earned $1.2 million net income for the year. At the start of the year it had 1 million stock shares outstanding (in the hands of its stockholders). Suppose the number of shares had remained the same during the year. In this scenario, EPS would be $1.20. A full amount of profit goes to each stock share that was outstanding at the start of the year. Fair enough.

Alternatively, suppose the business had granted several key executives stock options during the year for 200,000 shares, and these stock options are in the money at the end of the year (meaning the current market value of the stock is higher than the exercise prices of the stock options). Therefore, profit is spread over 1.2 million shares, and the diluted EPS is only $1.00. Market value depends on diluted EPS (see Chapter 13 for more details). In this scenario, EPS and the stock's market value are penalized. Part of the profit benefit was diverted from the original stockholders to the executives via the stock options.

In contrast, suppose that during the year the business purchased and retired 200,000 shares of its capital stock. In this situation, EPS would be $1.50 ($1.2 million net income ÷ 800,000 shares). Businesses with surplus cash argue that the best thing to do is to buy some of their own stock shares, which reduces the number of shares outstanding and increases EPS.