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QUALIPORT
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"It seems to me that the realities of stock options can be summarised quite simply: If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?" Warren Buffet wrote those words in 1993. Nine years on, a storm of protest has finally convinced many US firms to charge the cost of share options to their profit and loss accounts. Two years ago, the Qualiport looked at the ins and outs of accounting for options. (Background information on share options and why they're important to shareholders can be found here and here). After perusing through the accounts of the then Qualiport members, the conclusion on trying to put a 'shareholder cost' on share options was: "The average investor would have little chance of fully interpreting the current impact of options. Non-uniform disclosure, with some companies operating a multitude of employee schemes, gives little help towards making any convincing judgment." At the time, the Accounting Standards Board was contemplating a "radical plan" to alter the reporting of share options in UK company accounts. Unfortunately, there has been no subsequent change (as yet) in the way options (and their cost) are presented. Dilution So how can investors tell if a company's share option scheme is being overly generous? Probably the easiest way to check if something is amiss is to compare the company's basic earnings per share (EPS) with its diluted earnings per share. As well as the basic EPS figure, FRS14 dictates that listed companies must also report a diluted EPS number. Essentially, the diluted EPS calculation assumes any outstanding 'in the money' options (i.e. those with an exercise price lower than the market price) at the year-end were exercised during the year. The calculation also adjusts the earnings figure to account for the money received (and interested paid thereon) via the option exercise. Generally speaking, the greater the difference between basic and diluted EPS, the greater the chance of a charitable option scheme in operation. Using the latest results from Games Workshop (LSE: GAW), here's an example of diluted EPS reporting: Thus, if every Games Workshop option holder had exercised their options in fiscal 2002, the company's reported earnings would have been reduced by 2.5% (from 28.2p per share to 27.5p). Here's how the Qualiport watch list measure up in the dilution stakes: There doesn't seem to be too much to worry about here, with most companies having a potential share dilution of below 1%. Issues However, when looking at share dilution, there are three issues to watch out for: * Signficant share price moves: If a company experiences a sudden share price decline, then the potential for dilution reduces as 'in the money' options become 'out of the money'. Alternatively, if the company experiences a sudden share price rise, then the potential for dilution increases as 'out of the money' options become 'in the money. A good example of the latter comes from Games Workshop. In the year to May 2001, the company's 1.9m outstanding options just added 384,302 shares to the dilution calculation. One year and a near doubling of the share price later, 1.4m outstanding options added 708,818 shares to the diluted EPS figure. * Things other than options: Although nothing to do with liberal share option schemes, the presence of various 'convertibles' and warrants can also lead to earnings dilution. Ulster Television (LSE: UTV) presents a good example. Ulster's purchase of County Media last year involved the issue of a convertible loan note, whereby the note's holder can opt to redeem the debt into Ulster shares at a specific time. The bulk of Ulster's potential 3.1% dilution (the highest on the watch list) involves this particular instrument. * Incorrect calculation: It may seem obvious (and FRS14 does state this), but diluted EPS should not be calculated on more favourable terms than basic EPS. The excellent Companyreporting.com highlights one notable miscalculation. The 2002 annual report from Vodafone (LSE: VOD) includes this accounting note: It appears that Vodafone has included 'out of the money' options when determining the diluted number of shares in issue. Including such options ultimately results in a diluted share count lower than the basic share count before the dilution! More: Accounting For Qualiport Options: Part 1 and Part 2 | Companyreporting.com The author owns shares in Games WorkshopYear ending May 31st 2002 2001
Basic earnings per share 28.2p 18.4p
Diluted earnings per share 27.5p 18.2p
Weighted average number of shares:
For basic earnings per ordinary share 30,485,802 31,276,803
Dilution effect of share options outstanding 708,818 384,302
For diluted earnings per ordinary share 31,194,620 31,661,105
Company Weighted average number of shares Dilution
basic diluted (%)
(000s) (000s)
Allied Domecq 1,054,000 1,055,000 0.09
Carpetright 75,226 75,241 0.02
DFS Furniture 103,746 104,862 1.08
Emap 254,000 255,000 0.39
Gallaher 628,016 629,896 0.30
Games Workshop 30,486 31,277 2.33
Imperial Tobacco 516,887 520,304 0.66
Johnston Press 201,164 202,197 0.51
Lloyds TSB 5,533,000 5,583,000 0.90
London Stock Exchange 291,800 293,900 0.72
Metal Bulletin 54,267 54,675 0.75
PizzaExpress 69,800 70,000 0.29
Renishaw 72,789 72,789 0.00
SSL International 189,100 189,400 0.16
Ulster Television 52,547 54,177 3.10
Ultraframe 93,613 93,829 0.23
10. Earnings per share
Year to March 31st 2002 2001
Weighted average number of shares
(millions) in issue during the year
and used to calculate:
Basic and adjusted EPS 67,961 61,439
Dilutive effect of employee share options (246) (41)
Diluted EPS 67,715 61,398