With widely held companies such as Cisco Systems (NASDAQ:CSCO), Starbucks (NASDAQ:SBUX), and Motley Fool Hidden Gems selection CNS (NASDAQ:CNXS) issuing stock options, as well as periodically repurchasing large amounts of their shares, it makes sense to look at what effects these corporate activities have on financial reporting. But to do so, we need to look at both the short-term and long-term effects of these activities.
Perhaps the most important thing to realize about share counts is that the basic and diluted share-count numbers reported on the income statement (which are used to calculate earnings per share) are weighted averages and do not reflect the actual share count at the end of a fiscal quarter or year. To find the actual period-ending share count, we need to check the share count listed on the balance sheet. Let's look at a theoretical example to make this clearer.
Consider a theoretical company that has a Jan. 1-to-Dec. 31 fiscal year with 100 shares outstanding on Jan. 1. Next, let's assume that the company's stock price rises 20% early in its fiscal year. The rise in the share price will likely cause options holders to exercise some of their call options that are "in the money" (i.e., the strike price of the call options is below the stock price). Let's assume that the company's employees exercised options on 10 shares on Feb. 28, bringing the share count to 110.
Continuing with this example, let's assume that the company's share price remains relatively stagnant for the rest of the year but that the business itself continues to flourish, thus making the company's shares look undervalued. Seeing a good opportunity to return value to shareholders, management decides to repurchase 12 of its shares at the end of November. The repurchase brings the share count at the end of November back down to 98 (110 minus 12). No further corporate activity takes place during December, so the 98 share count is the number that would appear on the balance sheet at the end of the fiscal year.
But the number that appears on the income statement for basic shares outstanding is different and requires a little bit of math, because we need to take a weighted average, which is laid out below.
| Shares | Duration Outstanding | Weighted Shares |
|---|---|---|
| 100 initial shares | 12 months | (100*12) = 1200 shares |
| 10 issued | 10 months | (10*10) = 100 shares |
| -12 repurchased | 1 month | (-12*1) = -12 shares |
| 1288 shares / 12 = | ||
| 107.33 average shares |
As you can see above, the weighted average basic share count is 107 shares, which makes it appear as though shareholders were diluted by 7%, when the actual share count of 98 shares at the end of the fiscal year reveals no dilution at all. However, assuming that options exercises and company repurchases are infrequent, the weighted-average share count and the period-ending share count will converge in the long term.
The important thing to note is that the timing of share repurchases and option exercises can have an effect on the share counts you see on the income statement. In general, the difference in share counts aren't as outsized as they appear in this example, because share repurchases and options often are pretty evenly matched and continuous throughout the course of a fiscal year. However, a large repurchase at the beginning of a year combined with a large option exercise at the end of the year would cause a severe discrepancy between share counts.
At the end of the day, neither the ending-period share count nor the weighted-average share count is a perfect measure of a company's shares outstanding, because the number is so often a moving target. However, both ending-period and weighted-average share counts give investors the information they need to make rational decisions on whether a company's earnings were as strong (or weak) as they appear. Furthermore, studying past share-count discrepancies can help investors estimate future share repurchases and options exercises and their likely effect on a company's future earnings potential. The bottom line: Digging deeper into a company's financial statements -- and double-checking -- can sometimes yield valuable investment insights.
For related accounting Foolishness:
CNS is a Motley Fool Hidden Gems recommendation.
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Nathan Parmelee owns shares in Starbucks but has no financial stake in any of the companies mentioned. The Motley Fool has an ironclad disclosure policy.
