Before discussing valuation ratios, it’s worthwhile to briefly review some concepts that are integral to the interpretation and calculation of the most commonly used per share indicators.
Per-share data can involve any number of items in a company’s financial position. In corporate financial reporting – such as the annual report, Forms 10-K and 10-Q (annual and quarterly reports, respectively, to the SEC) – most per-share data can be found in these statements, including earnings and dividends.
Additional per-share items (which are often reported by investment research services) also include sales (revenue), earnings growth and cash flow. To calculate sales, earnings and cash flow per share, a weighted average of the number of shares outstanding is used. For book value per share, the fiscal yearend number of shares is used. Investors can rely on companies and investment research services to report earnings per share on this basis.
Basic Versus Diluted Income
In the case of earnings per share, a distinction is made between basic and diluted income per share. In the case of the latter, companies with outstanding warrants, stock options, and convertible preferred shares and bonds would report diluted earnings per share in addition to their basic earnings per share.
The concept behind this treatment is that if converted to common shares, all these convertible securities would increase a company’s shares outstanding. While it is unlikely for any or all of these items to be exchanged for common stock in their entirety at the same time, conservative accounting conventions dictate that this potential dilution (an increase in a company’s shares outstanding) be reported. Therefore, earnings per share come in two varieties – basic and diluted (also referred to as fully diluted).
An investor should carefully consider the diluted share amount if it differs significantly from the basic share amount. A company’s share price could suffer if a large number of the option holders of its convertible securities decide to switch to stock.
For example, let’s say that XYZ Corp. currently has one million shares outstanding, one million in convertible options outstanding (assumes each option gives the right to buy one share), and the company’s earnings per share are $3. If all the options were exercised (converted), there would be two million shares outstanding. In this extreme example, XYZ’s earnings per share would drop from $3 to $1.50 and its share place would plummet.
While it is not very common, when companies sell off and/or shut down a component of their operations, their earnings per share (both basic and diluted) will be reported with an additional qualification, which is presented as being based on continuing and discontinued operations.
The absolute dollar amounts for earnings, sales, cash flow and book value are worthwhile for investors to review on a year-to-year basis. However, in order for this data to be used in calculating investment valuations, these dollar amounts must be converted to a per-share basis and compared to a stock’s current price. It is this comparison that gives rise to the common use of the expression “multiple” when referring to the relationship of a company’s stock price (per share) to its per-share metrics of earnings, sales, cash flow and book value. These so-called valuation ratios provide investors with an estimation, albeit a simplistic one, of whether a stock price is too high, reasonable, or a bargain as an investment opportunity.
Lastly, it is very important to once again to remind investors that while some financial ratios have general rules (or a broad application), in most instances it is a prudent practice to look at a company’s historical performance and use peer company/industry comparisons to put any given company’s ratio in perspective. This is particularly true of investment valuation ratios. This paragraph, therefore, should be considered as an integral part of the discussion of each of the following ratios.