[generic news] <A> WSJ: Heard On Street: New Rule Gives Better Look At Options
By Elizabeth MacDonald
Staff Reporter of The Wall Street Journal
An accounting rule that just took effect may soon give investors a clearer picture of how companies' earnings are diluted by generous stock-option packages.
But the transition could generate some confusion as companies make their reports for the quarter that ended Dec. 31 under the new rules, requiring some adjustment of such key yardsticks as price/earnings ratios and expected quarterly per-share earnings.
"Investors need to be especially wary of fourth-quarter earnings numbers," said Gabrielle Napolitano, an accounting expert at Goldman Sachs.
The new rule, effective Dec. 15, won't affect the level of reported net income. What is changing is the definition of earnings per share. Under the new terminology, what used to be called simple, primary and fully-diluted earnings per share will disappear. Instead, companies will report both basic and diluted versions.
Under the old rules, companies could report earnings per share in three different ways: simple, primary, and fully diluted.
The "simple" number, was, well, simple-net income (minus preferred dividends) divided by the average number of shares outstanding. But that didn't count certain securities and options companies had issued to employees and others to buy common stock, an increasingly used incentive that can quickly inflate the number of shares outstanding, eventually diluting per-share earnings.
The old "primary" number did include the dilutive effect of options, warrants and some convertible securities containing options that were "in the money," meaning exercisable at a price less than the market price. But it didn't include certain convertible debt or preferred securities. That's where fully diluted came in, to reflect all those dilutive securities. Companies were required to report primary or fully diluted EPS if those numbers differed from simple EPS by 3% or more.
But investors were sometimes left in the dark about the potential future impact of options packages because many companies didn't report simple earnings. "Prior to the rule change, about 85% of all companies were reporting only the primary number," said Chuck Hill, research director for First Call Corp., a Boston distributor of corporate earnings research.
Companies were required by the old accounting rules to report both the simple and primary or fully-diluted number, whichever was more diluted. "But in some cases they weren't showing the simple number," said Kim Petrone, the EPS project manager at the Financial Accounting Standards Board. Companies "were not applying the rules the way they should have been." She added that companies tended to report "more primary than fully diluted" numbers.
With its new rules, the FASB abolished the primary number and the 3% test. Instead, companies must report only two EPS figures, basic and diluted. The basic number is essentially the same as the old simple EPS. The new diluted EPS is equivalent to the old fully diluted number. Robert Willens, an accounting expert at Lehman Brothers, says market watchers "should rely on the diluted figure for valuation purposes."
The differences promise to be considerable for many companies, according to a study by Pat McConnell and David Zion, accounting experts at Bear Stearns.
Take Dell Computer. For the nine months ended in September, Dell's basic EPS was $1.99. But options and other dilutive securities would add 30 million shares to its 334 million common shares outstanding, dragging its diluted EPS down to $1.81, a difference of 9%.
Travelers Group would have shown a basic EPS number 5% higher than its diluted figure for the same period, largely because it has 51.2 million shares from warrants, options, and its stock-based incentive plan in addition to its 918.7 million shares outstanding. Microsoft's basic EPS number, $2.87, was 8% higher than its diluted number, $2.63, for the fiscal year ended June 30, 1997, because stock options would add 108 million shares to its 1.2 billion shares outstanding.
In all three cases, those lower diluted numbers are nearly identical to the earnings per share the companies actually reported in those periods.
The Wall Street Journal plans to publish both the diluted and basic EPS figures in its earnings digest. It will also change the price-earnings ratios in its stock tables to reflect the diluted number based on corporations' trailing 12 months' earnings; in the past it reflected primary EPS. Dow Jones Newswires plans to report both numbers in its tables.
Associated Press and Reuters plan to report diluted EPS. First Call and IBES International, a New York financial-information company, will report diluted EPS. But in a possible complication for market watchers, Standard & Poor's plans to use the less-conservative basic EPS number that doesn't include options in calculations associated with its S&P 500 index.
Elliott Shurgin, chairman of the Standard & Poor's index committee, said S&P will use the basic EPS number in calculating the S&P 500's earnings and price-earnings ratios, two key market barometers. Previously, it had used primary EPS.
S&P's decision worries some experts. "Basic is closer to primary? That's wrong, because primary is much more diluted than basic," said Jack Ciesielski, editor of the Accounting Analyst's Observer, a stock-analyst publication in Baltimore.
Lehman's Mr. Willens contends that S&P's stance "could cause price-earnings multiples to look unduly low, especially for fourth-quarter numbers, when companies tend to write off a ton of year-end charges. That, in turn, could cause analysts and stock watchers to incorrectly conclude that the market looks cheap. . .based on unrepresentative EPS data."
"Basic is a lot closer to the primary than diluted would be," Mr. Shurgin responds. "Maybe by reporting primary all these years, we're understating the multiple, maybe so, maybe not, but we're going to be consistent." Mr. Shurgin said the rating agency will use diluted EPS for its valuations of companies.
Beyond those issues, Mr. Ciesielski fears that many analysts still don't understand the difference between basic and diluted. If they misinterpret the lower earnings number as an earnings shortfall, "momentum investors might start blindly dumping shares."
While the new rules will shed more light on companies that are exposed to future earnings dilution via unexercised employee stock options, Goldman's Ms. Napolitano says another wrinkle will actually help some companies with generous stock option programs, particularly among hightech, airline, financial-service, lodging and restaurant companies.
Under the old rules for calculating fully diluted earnings, companies were required to use the higher of either the closing price on the last day of the quarter, or the average price during the quarter to determine the level of dilution from its outstanding options and warrants. Now, companies must use the average market price during the quarter.
"If a company's stock has risen during the period, there will be less dilution, and that means higher earnings per share, lower P/Es, and possibly higher stock prices," said Ms. McConnell. Investors in companies that are more capital-intensive and tend not to use stock options as generously, such as those in the utilities, steel, chemical and paper industries, will see little benefit from these changes.
The new rule will also require companies to restate 1996 earnings to reflect the two new numbers. Going forward, companies will also have to change earnings history tables in their annual reports to accommodate the changes. Stock watchers who want to compare annual numbers will also have to wrestle with disparate numbers from companies that report on a fiscal-year basis.
The FASB opted to make the change in order to make it easier for investors to compare U.S. companies with foreign corporations, which typically report basic and diluted EPS. "We wanted to simplify the rules and bring them in line with global accounting standards," said the FASB's Ms. Petrone.
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Earnings Comparisons
How three companies' basic and diluted earnings per share would have looked under new accounting rules that took effect Dec. 15, 1997
-- Earnings per share --
Company Basic Diluted Difference
Dell $1.99 $1.81 9%
Microsoft 2.87 2.63 8
Travelers 2.25 2.13 5
NOTE: Figures for the nine months ending Sept. 30, 1997 except Microsoft's which are for the fiscal year ended June 30, 1997
Source: Bear Stearns
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Already dominant in the U.S. bicycle-helmet business, Bell was just introducing ski helmets in competition with European makers such as Boeri and Birko when the tragedies struck. Bell plans to unveil a second ski-helmet line in March under the Giro label.
-- E.S. Browning |
