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To: brushwud who wrote (174592)	5/15/2003 2:35:51 AM
From: Stock Farmer	Read Replies (1) \| Respond to of 186894

Thanks. As to "What would be the rationale for charging the estimated value of options to the bottom line, and then also diluting the EPS as if the options will surely be exercised? Great question. Don't know what you (or lurkers) know, so starting from scratch. First, dilution. Dilution is not an increase in the number of shares. It is a decrease in the value of the shares that are held. Let's say we have a company where the shares are worth $100 and there are 99 shares. Total value $9,900. Now, let's say the company issues another share and receives $100 for it. That makes 100 shares and total value $10,000. And each of those 99 shares are still worth $100. No dilution! But what happens when the company issues another share and receives $0 for it? Still 100 shares, but now total value is $9,900 and each of those previous 99 shares has been diluted in value by $1. Antidilutive works the other way around (issue share, get $200, 99 shares increase in value by $1). Now let's switch to the option scenario. We have 99 shares at $100 each and we granted one option. Let's also pretend that excluding the effects of stock options, the company earned $99 this period, or $1.00 per share. But what if we expect that the option we granted in this period will be further dilutive on exercise by $99? Our shareholders' expected net wealth actually increased by zero! It went up by the $99 the company earned for them, but down by the $99 that we expect them to be diluted by in the future due to the option we granted in this period. And if we only expect that the option will be dilutive by $9.90, then our shareholders' expected net wealth increased by $89.10 in the period. The classical definition of "profit" is a change in wealth of shareholders. Classical accounting principles are that the profit of the company reported in a period should accurately reflect the profit generated (or reasonably expected to be generated) during that period. Since the issuing of a stock option in the consequence of operating activities triggers a reasonable expectation of a dilution cost (negative profit), classical accounting suggests that it is reasonable to add the expected (negative) profit to the operating results. Thus, it's reasonable to add this expected dilution to EPS. That is the rationale for charging the estimated value of options to the bottom line. Hopefully this has answered part 1 of your question. As to the second part (questioning the rationale for also diluting EPS as if the options will surely be exercised), we don't want to do this. Need to understand what "fully diluted means". Back to our 99 shares, one option, $99 earnings before option cost. First excluding option cost. That might lend us to think that EPS is $1.00 or $0.99 "fully diluted". But not so. The way we calculate "fully diluted" is as if the option was exercised and the proceeds used to buy back a share. At the prices during the period! Right off the bat it should be clear that options granted in the period at fair value (intrinsic value = zero) should be approximately nondilutive (or zero). But we can be more precise. Going back to our expectation of a dilution of $9.90 and assume that by the end of the period the option is already dilutive by $0.90 which increases the share count for "fully diluted" purposes by 0.009 shares. Without expensing stock options we would have an EPS of $1.00 and a fully diluted EPS of $0.9999 Which hardly reflects the impact on shareholder wealth of having issued an IOU expected to be worth $0.10 per share. But expensing stock options, we have an opportunity for a bit of double counting. If we've expensed $0.10 per share in expected stock option cost, and we allow ourselves to include the dilutive effects of part of that (e.g. the 0.009 share increase), then we would have a bit of double counting (basicly counting the $0.90 of the $9.90 twice). But that is one of those niggly technical details that is easily resolved. For example, by calculating the effective fully diluted shares using the existing treasury stock method but excluding stock options issued during the reporting period. This corrective step is very similar to the adding back of interest on a convertible prior to calculating fully diluted EPS, which is amongst several of the fairly complex adjustments necessary to compute Fully Diluted EPS. Since it's already mind numbingly complex, making it a bit more complex is really only going to impact folk whose minds are already numb. John

To: brushwud who wrote (174592)	5/15/2003 4:38:21 AM
From: rkral	Respond to of 186894

OT ... brushwud, re "Basically, the cost (interest) is deducted from the basic income statement as if conversion is not an issue, but when it becomes more conservative to assume that dilution will take place, then the interest paid is added back before calculating fully diluted EPS." That's more than half true, but not entirely so AFAIK. Reported "diluted EPS" only assumes conversion, if the conversion would be dilutive to EPS. For clarification: "Diluted EPS #1" is calculated assuming no conversion. "Diluted EPS #2" is calculated assuming conversion. Reported "diluted EPS" is then the lower of the two. If there is more than one convertible issued, diluted EPS assumes conversion of only those issues that are EPS dilutive. IOW, each convertible is first tested individually. So re convertibles, diluted EPS is truly conservative, as you said. But it is conservative because it is "worst-case", not because conversion is assumed. Regards, Ron P.S. For those wishing to make their own interpretation, see SFAS 128 "Earnings per Share", paragraphs 13, 14, and illustration 4 in appendix C