Author: Nitin Garg

What is Diluted EPS? How is it calculated?

Nitin Garg1 Comment

This article is Part2 of my previous article on Earnings Per Share. In this article, I’ll discuss Diluted EPS along with different methods to calculate it. You may want to review Part1 of this article on Basic EPS here.

Part2: Diluted Earnings Per Share (Diluted EPS)

Diluted EPS is one which is calculated after all the convertible securities are converted into common stock. If a company has convertible securities (that is, if the company has complex capital structure), its basic EPS is greater than diluted EPS. And, if a company has a simple capital structure, its basic EPS is equal to diluted EPS.

Calculating diluted EPS

There are three scenarios that arises while calculating diluted EPS: (1) Convertible Preferred Stock, (2) Convertible Debt, and (3) Employee Stock Options. Let’s discuss them in detail.

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What is Earnings Per Share? How is it calculated?

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Earnings Per Share (EPS), an input to Price/Earnings (P/E) ratio, allows the shareholder to calculate his/her share of the company’s earnings. EPS can be classified into two – Basic and Diluted. Calculation of EPS requires that we have information on the company’s capital structure – simplex or complex.

A company is said to have complex capital structure when its securities (like convertible bonds, convertible preferred stock, employee stock options, etc) are convertible into common stock, and a company with no such convertible securities is said to have a simple capital structure. The distinction between the two is important while calculating EPS because any potential convertible securities can dilute (i.e., decrease) it. That’s why accounting standards like IFRS require public companies to disclose both basic and diluted EPS on the income statement.

In this article – Part1, I’ll discuss Basic EPS and in Part2, I’ll cover Diluted EPS.

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Information Technology Industry: Business Drivers, Strategies, Risks, Money-Making & Future Outlook

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ITWell, before we talk about the money-making process, let’s try and understand the key business drivers of the technology industry. And by technology, I’m referring to Computer Software and Hardware (excluding mobile handsets/cellular phones) industry. I’ll combine the money-making process along with the business drivers.

Key business drivers of technology industry

(1) Cost of sales

For a technology company, the cost of sales is fairly low. The Cost of Sales include

  • Cost of technology upgrades (including cost of development). Usually the upgrades are released every year.
  • Cost of hardware refresh: Usually, most of the technology companies have an enterprise wide agreement for their server and storage upgrade [like IBM (NYSE: IBM), HP (NYSE: HP), Dell and Oracle (NYSE: ORCL)] and networking equipments upgrade like Cisco (NASDAQ: CSCO). The refresh period is usually 3-5 years.
  • Cost of documentation, duplicating software, training, packaging (if media is supplied) and cost of maintenance (predominantly data center maintenance other than what has been specified in ‘Point b’ above): Now-a-days, most of the companies enable software download feature to avoid costs associated with documentation and media.

These three costs account for 15-20% of the sales revenue, leaving 85% for Selling, General and Administrative Expenses (SG&A), Marketing and Research & Development (R&D). Hence, it’s not surprising to see Technology companies investing handsome amounts in Marketing and R&D. To give you a perspective, in FY11, Oracle invested $ 4.5 billion in R&D. With $ 35.6 billion in total revenues, that’s 12%, a good investment for Oracle.

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Seven questions to ask yourself before executing your product idea

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There are four aspects that needs to be covered when we think of a new product idea.

Product Strategy

  • What problem is my product solving?
  • How is it different from the existing products in the market? What is its USP?
  • How does it fit into my existing product line (assuming this is not a start-up)? This is very important thought as there is always a danger of cannibalizing our own product that may be generating good revenue. At times, we might have to evaluate the amount of revenue your latest product will generate compared to its predecessor.

Customer Strategy

  • Who is my customer?
  • Why is he going to buy from me? What’s the value he gets?
  • How do we reach them? Can we reach them through Internet? (Internet is revolutionizing the way we do our business today)
  • How do we retain them?

Market Strategy

  • How does it affect my existing product line? Is it going to replace them? Does it cannibalize them?
  • Is this idea a reaction to my suppliers’, customers’ or competitors’ move?
  • Does it increase my sales revenue or my customer base?
  • Is the idea catering to a new market? If yes, we might want to look at many aspects, but predominantly barriers to entry and exit, players, size, growth, life-cycle of the economy and industry, impact of technology (internet), …
  • Who are the players in the market and their market share? How would the competitor respond to it?

Financing

  • How would you finance the product launch, if we get a ‘Go-ahead’?
  • What happens if the economy sours? How will I pay the debt, if I’m raising funds for it?

We need to understand the supply and demand aspect of the game. Many a times, we invest in new things only to realize that it’s a “desire” (and not a need) in the market. We approach the prospect and try to force sell them by continuous education/campaign. That is when the cost goes up. I suggest we do a demand analysis with a strong perspective on competitors move in such an area, and then try to find out why the other players haven’t done anything with it.

Questions I’d ask myself are:

  • Is there sufficient demand for such a product idea?
  • What’s the supply?
  • Why haven’t others identified it yet?
  • If they have, what are they doing with it?
  • Have they tried to cater to the need?
  • If they failed, what’s the reason behind it?
  • Are there any substitutes for it?
  • What are the barriers to entry and exit?

This post originally appeared in one of my blogs in public CXO forums: 

https://www.linkedin.com/groups/Seven-questions-ask-yourself-before-50556.S.263673928?view=&srchtype=discussedNews&gid=50556&item=263673928&type=member&trk=eml-anet_dig-b_pd-ttl-cn&fromEmail=&ut=3uETgoUjty-5Q1

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How would you add an extra $10m in revenue in the next year?

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First, we need to understand the external factors – economy and industry. The questions that we need to ask ourselves are:

  • What’s the size of the market?
  • What’s its growth rate?
  • Which stage of the life-cycle is it in?
  • Performance for the last 2 years (it would be very difficult for a start-up to take a leap unless we have ample amount of “qualified” pipeline to generate this revenue). I suggest we do a comprehensive analysis and do a Specific, Measurable, Achievable, Realistic and Time-constrained (S.M.A.R.T.) projection to avoid disappointment and hence the cost of the effort (which can be huge).

Growth Strategy

  • Increase distribution channels
  • Diversify product line
  • Increase product and services
  • Acquire competitors (this needs cost-benefit analysis and due diligence of M&A targets)

Increase Sales Revenue

  • Increase price. This has to be done with caution and need smart approach to pass it on the customer. We need to anticipate the competitors’ response and check the substitutes available in the market. Otherwise, the customers/prospects will run away from you! 😉
  • Increase per unit sale
  • Increase volume (get more buyers, increase distribution channels, hire sales force, …)
  • Create a seasonal sale, if applicable
  • Invest in major marketing (one that has proven to be fruitful). Digital marketing is most cost-effective and efficient for larger target audience. We can hire an advertising agency for this with KRA like number of leads and conversion rate for the pay-off.

There might require certain changes to the pricing strategy as well as compared to your competitors’ price

This post originally appeared in one of my blogs in public CXO forums:

https://www.linkedin.com/groupItem?view=&gid=50556&type=member&item=264797155&commentID=155864030&report.success=8ULbKyXO6NDvmoK7o030UNOYGZKrvdhBhypZ_w8EpQrrQI-BBjkmxwkEOwBjLE28YyDIxcyEO7_TA_giuRN#commentID_155864030

If you wish to gain any privilege to this blog, please write your message to the author through the page “CONTACT ME” by filling in the required details in the form, OR by dropping an e-mail to him at nitin@gargfinanceblog.com

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How do you capitalize an operating lease quickly?

Nitin Garg1 Comment

To answer this question, let’s consider an example. Assume following is an annual statement of a public company. “At December 31, 2000, the Company was lessee at 7,000 restaurant locations through ground leases (the Company leases the land and the Company or franchisee owns the building) and at 6,000 restaurant locations through improved leases (the Company leases land and buildings). Lease terms for most restaurants are generally for 20 years and, in many cases, provide for rent escalations and renewal options, with certain leases providing purchase options. For most locations, the Company is obligated for the related occupancy costs including property taxes, insurance and maintenance. In addition, the Company is lessee under non-cancelable leases covering offices and vehicles. Future minimum payments required under existing operating leases with initial terms of one year or more are:

($ millions) Restaurant Total
2001 $748.3 $811.6
2002 735.3 790.4
2003 705.8 752.2
2004 676.2 715.1
2005 623.5 640.0
Thereafter 6,018.7 6,239.7
Total minimum payments $9,507.8 $9,967.3

Rent expense was (in millions): 2000–$886.4; 1999–$796.3; 1998–$723.0. These amounts included percent rents in excess of minimum rents (in millions): 2000–$133.0; 1999–$117.1; 1998–$116.7. “ To capitalize these operating leases, we need to discount the future lease payments to arrive at the present value (PV). Here are the steps:

  1. Cash flow for the FY2000 – 2005 are already given. So, we proceed to Step 2
  2. Divide the “Thereafter” amount ($6,240M) by FY2005 amount ($640M) to determine the number of years remaining, at FY05 level, for the lease payments.

 6,240/640 = 10 years remaining

Put $624M (=$6,240M/10) for the additional 10 years after the lease amount of FY2005 for the PV calculation.

  1. Consider its long-term borrowing rate (6%) to match the long-term assets.
  1. Calculate the Present Value(PV) of this cash flow.
Year Payment ($millions)
2000 886.4
2001 811.6
2002 790.4
2003 752.2
2004 715.1
2005 640.0
2006 624.0
2007 624.0
2008 624.0
2009 624.0
2010 624.0
2011 624.0
2012 624.0
2013 624.0
2014 624.0
2015 624.0
PV @6% 6,500.0

Now, let’s adjust the financial statements. Capitalizing operating leases does not affect net income; it just replaces the lease expense with interest expense and depreciation

  1. $6.5B is added to the ‘Long-term Asset’ of the Balance Sheet as “Assets Under Capitalized Leases”. A similar amount is also added to the ‘Liabilities’ as “Capitalized Lease Obligations”. Now, this represents as if the company had purchased the assets with borrowed money as of 1/1/2000.
  2. Reverse the existing entry ‘Lease Expense’ currently in the financials. The company paid $886.4M in FY2000.
  3. Calculate the PV of FY2000 interest payment.

$6.5B x 6% = $390M

Since the company paid $886.4M in FY2000, the difference amount of $496M (=$886.4M – $390M) is added to the depreciation, resulting in no change in the net income value.

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