BITS > JUNE 2003

Reading the Fine Print in Financial Statements

CompuFest 2003

Editor's note: A special note of thanks to Diane Graese for sharing some of the highlights from one of her CompuFest presentation, Footnote Findings (4:10 p.m., June 28), with BITS readers. Diane has extensive experience working with financial statements and accounting issues. A founding member of the NAIC Online Investor's School, she is a frequent contributor on NAIC's I-Club-List. She is also a director of NAIC's Las Vegas Chapter.

In "Footnote Findings," I will take you through some sample footnotes highlighting information you can use in your Stock Selection Guide (SSG) preparation and stock studies. This is an advanced level presentation focusing on debt, pension, earnings per share and stock option footnotes.

The earnings per share (EPS) footnote will be the focus of this article. The footnote from Rehabcare Group Inc.'s 1999 Annual Report on Form 10-K is included as an exhibit below. The full report is available at my favorite book marked site: www.sec.gov .

S&P Compustat, the provider of Online Premium Services (OPS) data and Value Line have analysts who read company annual reports and put numbers into their respective proprietary formats. These are both excellent sources for data to create SSGs.

But I would NEVER purchase a stock based solely on the data imported into my SSG software. There's always more homework needed.

We should all have a checklist of things we want to explore before we are comfortable with both the underlying data in our SSG and the assumptions we are making about the future. One step is to review the annual report. But it can be a meaningless exercise if you don't know what you should be looking for. Bob Adams, Chris Collins, Bart Womack and others will have classes at CompuFest helping you with annual reports and the financial statements. I'm going to take you through some "fine print."

Earnings Per Share Data

Both Value Line and OPS report "normalized" diluted EPS, unless the company only reports basic EPS (meaning there is no dilution). Analysts have removed what they consider to be unusual and/or nonrecurring items.

Value Line includes a footnote at the bottom of the page to show adjustments made by amount and by year. In this manner, you can determine if adjustments are frequent or infrequent and the relative size of such adjustments. Remember, these gains and more likely losses DO impact shareholder equity.

If you use OPS, you don't have the benefit of knowing what type of adjustments have been made to "normalize" the data. I have long proposed that the Company Report page should, at a minimum, show earnings per share "as reported" so one can see the difference in the numbers before downloading SSG data. To me, large and recurring adjustments are a red flag that mean I will need more time to study a stock.

What method do you use to estimate future EPS? If you draw trend lines, then you are making assumptions about the ability of the company to repeat past trends. At a minimum, you should read the "Letter to Shareholders" in the annual report. While this is not a footnote, it's the place where management is supposed to explain its plan to generate future earnings. While management is generally conservative in its predictions, if it's predicting 10 percent growth, your SSG should not be predicting 20 percent growth.

The rest of this article is for those who use the preferred procedure. Users attempt to create an expected future income statement and earnings per share calculation. This method allows the user to examine all the variables contributing to future performance and to rationalize how they think the company will generate future earnings. Although the formula seems simple enough (and it's really easy if you use software to do your SSGs), there are subtleties that have arisen in recent times.

Changes to EPS calculations

Value Line also has another footnote regarding EPS data. It tells you what type of EPS data is being presented. It may be primary EPS or diluted EPS or some combination. Frequently the footnote says "primary earnings through 1996; then diluted." The relevant footnote finding is that the formula to calculate EPS changed in 1997 when the Financial Accounting Standards Board (FASB) issued Statement No. 128, Earnings per Share.

Diluted EPS is calculated to create a "pro forma" number, earnings "as if" dilutive shares were in existence and claiming their share of profits.

Reporting of diluted EPS should raise a flag to do more homework. First, you'll need to know if there's a significant difference between basic EPS and diluted EPS. You can look at the bottom of an income statement in an annual report or in a recent earnings press release.

Dilution

Let's look at our example. In the Rehabcare (RHB) footnote (Figure 1, below), we see basic EPS for 1999 is $2.30; diluted EPS is $2.07. The difference is $.23 or 10 percent of basic EPS. Is this difference significant? There are all sorts of rules of thumb about where to draw the line. I tend to use 5 percent but many people use a lower figure. I think it also depends on the company, its industry and common compensation plans, growth rates, and the dilution source. Most dilution tends to come from stock options, another footnote we'll examine in this presentation.

Click to enlarge.

Figure 1: Earnings per share footnote from Rehabcare Group, Inc. financial statements.

In my opinion, RHB does have significant dilution so we need to understand what impacts the EPS calculation currently and consider how to factor those items into our future EPS calculation.

The Formula

The "expected income statement method" (a name I like for the preferred procedure) starts by growing revenues at some rate for the next five years. Assumptions are made about the future pre-tax profit margin and future tax rate (or a net profit margin) and applied to future revenues to arrive at projected future net income. This figure is reduced by preferred dividends and then divided by future shares to arrive at projected future earnings per share.

When using software, this seems easy enough. But there are two potential problems. One: the above formula may not be the same formula the company is using to calculate diluted EPS. Two: the number of shares in OPS and Value Line data are also likely to not be the same number of shares used to calculate diluted EPS.

Adjustments to Net Income

The first footnote finding should be whether net income in the EPS calculation agrees with net income reported on the bottom of the income statement. We know that preferred dividends need to get subtracted, so we want to make sure our data source has captured the correct information. The other typical adjustment to net income is for interest expense on convertible debt.

Convertible debt is a potentially dilutive security. This debt is normally issued at a lower interest rate than non-convertible debt. Debt holders are enticed to hold this security because it gives them the ability to trade the debt for common stock under specified circumstances at specified conversion rates. Thus this debt has some features of debt and some features of equity. When it's likely that the debt might get converted, these additional shares get factored into the diluted EPS calculation.

Since the EPS calculation assumes the debt has been traded for shares, the interest expense (net of tax) paid to these security holders is added back to net income. They can't get both interest income and earnings per share -- that would be a double dip.

You'll have to read the debt footnote to find out more about the conversion dates so you can determine how to factor this security into your future EPS computations. There would also be adjustments to net income if there were dilutive convertible preferred stock.

Outstanding Shares

Value Line and OPS generally report outstanding shares as of the latest reporting date. These numbers may or may not reflect Treasury shares, shares held by the company and not included in outstanding shares for EPS calculation purposes.

The EPS calculation uses a weighted-average of outstanding shares. Thus any significant activity late in the year will not be weighted very heavily. It's a good idea to compare the number of shares used in calculating basic EPS to outstanding shares. While not only identifying Treasury shares, you may note increases to shares due to secondary offerings or as payment for an acquisition, or decreases in shares due to repurchases. Most of this activity can be found in the Statement of Changes in Stockholders Equity.

While current outstanding shares will reflect new issuances and/or repurchases, they don't include the additional dilutive shares used to calculate diluted EPS. Thus if you project no changes to these share figures, you're actually creating an EPS increase. By default, you have assumed future repurchases of outstanding shares.

Adjustments to Shares

In the RHB footnote, there are three adjustments to shares in the diluted EPS calculation. We have already discussed the increase to shares when it is assumed that convertible debt has been converted. There may also be other dilutive securities such as warrants or convertible preferred stock. Options are the most common dilutive security.

Options give the holder the right to purchase shares at a specific price (exercise price) over a certain period of time. Options are generally given to management as incentive compensation. They earn entitlement to the options over time (vesting). Generally the exercise price is the fair market value of the stock on the date the options are granted.

For options to be dilutive, the exercise price must be below current market prices. For dilutive options to be included in the EPS calculation, they must be vested.

The diluted EPS calculation assumes the money paid by the option holder upon exercise (exercise price times the number of option shares) will be used to repurchase shares in the open market to reduce the dilution. This may not be what eventually happens because the company may choose to issue new shares or Treasury shares, but at least it factors in the cash the company will receive when the options are exercised.

It's very likely there are many more shares that may become exercisable in the future. These are either currently unvested options or options where the current market price is less than the exercise price. To determine what adjustments to make to shares in your future EPS calculations, you will need to read the stock option footnote and make some assumptions. We'll look at that when we get to the stock option footnote. For now, it's quite reasonable to just adjust outstanding shares for the same number of option shares included in this footnote.

At RHB, there's also a third source of dilution -- contingent consideration. This arose when RHB acquired a company and agreed to issue additional shares of stock as payment for the purchase assuming certain conditions were met in the future.

In the RHB footnote, we see there's no further dilution from contingent consideration in 1999. A footnote on acquisitions (not shown) explains 48,433 shares were issued in 1999 in settlement of contingent consideration. In prior years we would have wanted to include these shares as an adjustment to outstanding shares for our future share estimates.

This example is far more complicated than what you're likely to see at most companies. Option shares tend to be the only dilutive adjustment. And that may change again as companies return to an old fashioned form of compensation -- cash.

There are still lots of outstanding option shares for RHB, however, so we should look not only at the EPS footnote but also the Stock Option footnote to determine what adjustments should be made in estimating the number of shares in our future EPS calculation. My CompuFest seminar examines that footnote as well.

Diane Graese was formerly an officer of the Computer Group Advisory Board and a director for the BetterInvesting Las Vegas Chapter. She is an active member of i-club-list and the BetterIinvesting Community at Compuserve. Diane is well known for her seminars on cash flow and interpreting financial statements. Contact Diane at dmg1031@aol.com.