extraordinaryitems.Thekeyistocomeupwithameasureof
earningsthatiscomparableacrossdifferentfirms.Withthat
objective inmind, itisquite clear thatwe shouldexclude
extraordinary items. However, there is one more
measurement questionthat wewill haveto confront when
measuring earnings per share. Should we use primary,
partially diluted, or fully diluted earnings per share? We
believethatallofthesemeasurescreatepotentialcomparison
problems.
If we use primary earnings per share, we are ignoring
managementandotheroptionsoutstandingandwillbiasour
analyses toward finding companies that have
disproportionatelylargenumbersoftheseoptionsoutstanding
tobeundervalued.Ifweusedilutedearningspershare,we
are assuming that thenumber of options outstanding is a
sufficient measure ofthe optionoverhangover equityand
thus we mete out equal penaltiesto firms with equivalent
numbersofoptionsoutstanding.Thiscanbeaproblemwhen
somecompanieshavelong-term,deepin-the-moneyoptions
outstanding and other companies have short-term
at-the-money or out-of-the-money options outstanding.
Clearly, the options will affect equity value more at the
formerandlessinthelatter,butusingfullydilutedearnings
per share will bias us toward finding the former to be
undervalued.
2 The advantage of using the option-augmented equity
approachisthatitconsidersthevaluesofoptionsoutstanding
rather than just the number of options.
- Equitycashflowmeasures.Therearemanyanalysts
andinvestorswhoarewaryofaccountingmeasures
ofearningsandwithgoodreason.Theyprefercash