Pay attention to diluted stock values

When you read a company’s income statement, you’ll generally see references to “diluted” and “basic” earnings per share. This differentiation is there thanks to a rule instituted by our friends on the Financial Accounting Standards Board (FASB) that went into effect in 1997. It requires companies to report their quarterly earnings per share (EPS) in two ways: basic and diluted.

This is important stuff for investors to understand, as per-share profits show an investor her share of a company’s total profits. Pay attention to the diluted numbers.

Basic EPS is net income less any preferred stock dividends, divided by the weighted average number of common stock shares outstanding during the reporting period. Diluted EPS takes into account in-the-money stock options, warrants, preferred stock and convertible debt securities, all of which can be converted into common stock, which would increase the number of shares outstanding. (“In-the-money” options are those exercisable below the current market price.) These common stock equivalents represent the potential claims of other owners on earnings and show the investor how much of the company’s earnings she’s entitled to, at a minimum.

Any increase in the number of shares of stock dilutes the earnings attributed to each share. The difference can be dramatic. For example, Netflix reported 79 cents per share in basic earnings for its fiscal year 2005, while fully diluted earnings were nearly 20 percent lower, at 64 cents per share. Options and other securities would have added about 12 million shares to the 53.3 million shares outstanding, increasing their number by 22 percent. Options are not all bad, though. Employee compensation in the form of options permits companies to attract and keep talented employees and also to reduce current salary expenses, leaving more money to help the firm grow.

Focusing on the diluted earnings can help investors more accurately determine how much of company earnings they’re entitled to and will convey a sense of what stock options actually cost a shareholder.

Ask the Fool

Q: If I invest in a penny stock, I’ll be able to buy more shares per dollar than I can with more expensive stocks. Then, when the shares go up, I’ll make more money, correct? — H.M., Fairfield, Calif.

A: No, no, no. It’s a common misconception that penny stocks are a bargain because you can buy so many for so little. Remember that both a $2 stock and an $80 one can go up (or down!) by 5 percent in one day. For the $2 stock, that means a 10 cent increase, to $2.10. For the $80 stock, it’s a $4 jump, to $84.

Penny stocks are more likely to eventually plummet than to skyrocket. They’re risky, often hyped and manipulated by those with dastardly designs. Steer clear and look instead to healthy, growing companies you understand.

In the last decade, you could have more than tripled your money in shares of ExxonMobil. You’d have more than doubled your money in Tootsie Roll.

My dumbest investment

When I bought my house in 1989, I didn’t have enough to put 20 percent down, but I still sold as much stock as possible to put 17.5 percent down. Unfortunately, I sold about $12,000 of Coca-Cola stock. Over the years that I’ve owned my home, the Coke stock would have increased in value by much more than my home’s value did.

I should have only sold enough to put 5 percent down, like the loan company required. At least I’ve had the benefit of the house for the last 16 years. — E.B., Lexington, Ky.

The Fool Responds: You didn’t necessarily do the wrong thing. By putting very little down, if your home’s value had dropped significantly, you’d have ended up owing more than it was worth. That would have hurt, if you’d had to sell it. Also, no stock’s future is certain. Coke might have gone flat over the years.

The Motley Fool Take

Card game equipment maker Shuffle Master (Nasdaq: SHFL) recently reported quarterly earnings, with net revenues up 49 percent to $40.7 million, operating income from continuing operations before taxes down 3 percent, and net income from continuing operations off 8 percent.

It wasn’t a spectacular quarter, income-wise, but revenue growth shone, thanks to the firm’s acquisition of Stargames.

Shuffle Master’s future is promising. The Asian market appears to be strong and should be a nice source of growth in years ahead.

Shuffle Master expects to grow revenues and earnings beyond 25 percent in the near future. If these expectations are met or surpassed, then cash flows should rise, contributing to a stronger balance sheet.

Of course, profit margins must be watched carefully; the operating margin this quarter was 32.5 percent, compared with 44 percent a year ago.

The company warrants consideration as a long-term investment. Gambling is an industry that should open up to more people in the coming decades as states increase their receptiveness to such an income-driving diversion. The margin scenario may be down right now, but revenues should continue increasing and shareholder value should reflect such positive tidings.