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Walking Through a Valuation Including Share Based Compensation

Today, one of the more controversial finance topics is share-based compensation or stock options issued to employees, particularly the C-suite managers. Because of incentives tied to those options, recently, there have been some not-so- shareholder-friendly behaviors.

Those behaviors have led many in Congress to believe that this type of compensation is undesirable for both investors and employees. The idea of a “golden parachute” is pretty much reviled and looked down on.

In most cases, issuing shares is a great way to align both the company and employee interests and is a great way to entice top talent to the company and encourage longer tenure.

The use of share-based compensation increases, especially among young, upcoming tech companies short on cash but long on potential, has grown exponentially over the last ten years. It is a great way to entice top talent, but accounting for that “real” expense is a little vague, at best.

Along with the vagaries of the accounting treatment is the lack of attention in valuation. Regardless of the accounting treatment, the cost of options is a real impact on a company’s value because these share-based options WILL be exercised someday, and that is a cash outlay to the company.

In today’s post, we will learn:

  • What is Share Based Compensation?
  • How Do We Value Share Based Compensation?
  • Walking Through Valuing Share Based Compensation
  • Investor Takeaway

Okay, let’s dive in and learn more about valuing share based compensation in valuation.

What is Share Based Compensation?

Share based compensation are also known as stock based compensation or stock options. Each company lists them slightly differently in their financial statements, and are a form of equity investment for the employee.

The company issues options in the form of a right to buy the company’s stock at some point in the future, typically with a vesting period. Once that vesting period or waiting period expires, then the employee has the right to exercise that option and receive their shares at that point.

The value of the options have two effects on the per-share value of the company:

  • The first issue is with options already granted; these options, most of which have exercise prices below the current stock price, reduce the value of the equity per share of Facebook. This lowering of the value is that Facebook has to set aside a portion of its Equity to meet the option’s eventual exercise.
  • The second issue is the likelihood that Facebook will continue granting options to employees ongoing as a method of rewarding or compensating employees. These future options further reduce the portion of future cash flows that shareholders might receive in the future.

The use of options as a means of compensation is nothing new, it has been around since the 1970s, but the impact was small as it was a small portion of management compensation. But in the last decade or so, with the rise in technology firms, there has been a surge in issuing options. And that surge is highlighting the need to deal with it in valuation.

What is so different about the new technology firms? One is that the weighting of management pay is more often heavier towards stock options than paying their employees. It is primarily because young start-ups are short on the cash to entice high-priced talent and long-term potential.

Much of the media focus on management, but these options are also granted to all levels of employees to encourage employment and longevity.

Another aspect of the use of options is some smaller companies issue stock options to pay for supplies or operating expenses.

All of these granting of options tie up the company’s Equity because at some point in the future, they will grant those options, and that cash flow and Equity flow out of the company.

Companies that use employee stock options restrict when and how these options can exercise. It is normal, for example, that an employee’s stock options cannot be exercised until they are vested, which means that that the employee needs to remain with the company for a stated period, typically two to three years.

The most obvious benefit to companies for this type of vesting is the increased retention of employees. But another benefit for the company is that Facebook won’t face any tax consequences in the year they issue those employee stock options. However, when the employee does exercise their stock options, Facebook is allowed to treat the difference between the issue price and exercise price as an employee expense. Beyond the decreasing of income for investors, it also alters the share-based compensation tax liabilities.

We are not accountants, and taxes are not my jam, but I think it is important to understand some of the benefits beyond the obvious ones. As Charlie Munger likes to say, “show me the incentives, and I will show you the result.”

If you want a deeper dive into share based compensation, might I recommend the link below to an article by Michael Mauboussin:

How Do We Value Share Based Compensation?

As we have seen above, there are many employee options in the market, and our first task is to consider methods to incorporate any effects in value per share of Facebook.

First, let’s look at why they affect per-share value.

So why do options affect the value of Facebook; first not all options affect value. Any options offered by an investment brokerage such as Schwab do not affect the value of Facebook.

But the employee stock options issued by Facebook do affect the value of the company. And that is because there is a chance that the options will be exercised either now or in the future.

Because of the nature of how the employee options are offered at a fixed price, they will only be exercised when Facebook’s stock price rises above the exercise price. Backing up for a moment, the exercise price is the selling price that the employee option gets. For example, if Facebook sells options to its employees at $200 and the price rises above that $200 when the options vest, then the employee stands to make a nice return.

Now when the options vest and employees exercise their options, the company has two options for dealing with them. And neither option is great for shareholders.

  1. Facebook can issue additional shares to cover the exercising of employee options. And this increases the number of shares outstanding and reduces the per-share value for shareholders. In effect, it is diluting the value per share for shareholders.
  2. The other option for Facebook is to go out into the marketplace and purchase shares on the open market and use those shares for the employee stock options. The purchase of stock reduces the cash flows available to shareholders in the future and reduces the value of the Equity today.

There are multiple ways to deal with valuing a company with share based compensation.

The first option is simple but not the most accurate because it assumes that all options are the same, and they most certainly are not. It doesn’t account for the difference between options that are restricted or in-the-money. Restricted options or RSUs are only available for vesting once certain requirements are met, such as earnings per share or profitability ratios. The in-the-money options mean they are available once they are vested or live once the period ends.

The other method is to use an option pricing model. Using this model, we have Facebook’s current value per share and the option’s time premium. After finding this value, we subtract it from the equity value and divide it by outstanding shares. All of that will allow us to find the “correct” value per share.

There are additional valuing share-based compensation methods, but they are not optimal; but if you want a deeper dive into those methods, check out the link.

Walking Through Valuing Share Based Compensation

We will use Facebook (FB) as our guinea pig for our walkthrough, and we will reference data from the most current 10-k, dated 12-31-2020.

To illustrate the options’ valuation, we will use a traditional DCF (discounted cash flow) model where we take the revenues and subtract out the operating costs, taxes, and reinvestment needs to find our free cash flows to the firm. If all of this is unfamiliar to you, please refer back to our post on discounted cash flows here.

Once we have our cash flows, we will discount those cash flows back to the present using a discount rate. And now that we have all those steps accomplished, we subtract out the debt and cash and find the Equity for Facebook value. Finally, we next find the value of the share based compensation or employee options.

The reason for looking at the equity’s value is that there are two claims on that Equity: the shareholders, and the other is the claim of the employee options. This means we need to subtract out the value of the employee options from the company’s value to determine what it is worth to shareholders.

The first step is to search through the 10-k or most recent financial statement looking for share-based compensation, employee options, or employee stock options. Unfortunately, there is no standardized terminology, so that it might take a bit of searching. My favorite way to search is to use the CTRL F function, which allows you to type in a phrase and search.

Typically, we will find information about the employee options in the notes sections of the financials, below the main financial statements, such as an income statement.

In Facebook’s case, it lists the info under Note 13. Stockholders’ Equity on page 106.

The first number we are going to look for is the number of options still outstanding.

As we can see from above, the total amount of unvested shares at the end of the period is 96,733 thousand.

The next important number is the weighted average exercise price.

So the average exercise price is $181.88, which, when the options vest, the employee can exercise their options to buy Facebook shares at $181.88. Let’s put that into dollars to highlight the strength of offering this to employees.

Let’s say you own 100 employee options of Facebook, and when they become vested, you opt to acquire your shares at $181.88. You now own $18,188 in Facebook shares, and then you choose to turnaround and sell those 100 shares at the current market price of $250, valued at $25,000. You would make $6,812 for a cool 37.45% on your money!

Back to valuing those options, on with the next step in gathering data.

The following data we need is to find the weighted average period of vesting period. It will sometimes list in the chart with the other information, but they write it out in a statement below the table in Facebook’s case. Unfortunately, you might have to search a bit to find it, but it will be there.

As we can see from the statement above, the average period is three years.

The final number we need is the standard deviation of the stock price, and to arrive at this number, we can find it sometimes in the financials by using our CTRL-F function. But in Facebook’s case, I refer back to Professor Damodaran’s website that lists it under tools. For our purposes, I will refer to the free cash flow to the firm spreadsheet that we will be using in the rest of the explanation.

Once we have downloaded the above spreadsheet, it’s free and customizable; we can finish valuing the share-based compensation.

The spreadsheet will do all the heavy lifting for us regarding the math; we only need the inputs to plug into the spreadsheet.

As we can see, it has the:

  • Strike price or the weighted average price of $181.88
  • Vesting period or expiration of options at three years
  • T-bill rate of 1.5%, which is the current 10-year T-bill
  • The current stock price of $259
  • Standard deviation we gathered from the related tab on the spreadsheet
  • Any dividends the company might pay, in Facebook’s case, equals zero
  • The total number of options outstanding we gathered first from the 10-k
  • And the total number of shares outstanding, also from the 10-k

After plugging in all the necessary inputs, the spreadsheet does the calculations for us to find the value of those outstanding options, which in this case:

Next, we take the highlighted number and subtract it from Facebook’s total equity value to find our per-share value.

To illustrate the impact on Facebook’s value, if we remove that line item from the calculations, we see the price per share increase:

We see the price increase from $384.35 to $389.61, which is an increase of almost 1.3%, which is not a big adjustment, but it is worth noting because it could throw off our margin of safety.

I think that helps illustrate the importance of the impact that the value of the share based compensation has on the equity value of Facebook. And to not include that in any calculation could lead to a misjudgment of the company’s value.

Investor Takeaway

The price we pay matters a lot and attempting to be as accurate as we can when doing any intrinsic valuation is important. Including items such as taxes, reinvestments, and operating costs are obvious. Not as obvious is including the impact of outstanding employee options.

As we can see from the above valuation of Facebook, it is a real cost, like any other such as interest expenses or the cost to produce a car. Therefore, it is important to include it in our valuation because it impacts the value of our shareholders’ equity.

Another benefit is it also helps give us a more conservative number, especially in low-interest rates, where valuations are already elevated, which is another margin of safety.

I didn’t include any of the actual math or formulas to calculate the value of the employee options because it gets a little convoluted in print; it is easier to use the spreadsheet that Professor Damodaran provides. If that floats your boat, I suggest you read the cell formulas to figure out the higher math.

But for our purposes of determining the intrinsic value of Facebook, it is more helpful to use the spreadsheet and think about the bigger picture; that is the benefit of using tools like his spreadsheet.

I take no credit for creating the spreadsheet, and the valuation of Facebook is only an example, not meant for investment advice, only as a teaching tool. The inputs for the final value are only estimates.

Including share-based compensation as a line item in the valuations is a minor part of finding the value but an important consideration. It is a real cost and should adjust the equity value of any company you value.

With that, we will wrap up our discussion on share based compensation and the impact on valuation.

As always, thank you for taking the time to read this post, and I hope you find something of value in your investing journey. If I can be of any further assistance, please don’t hesitate to let me know.

Until next time, take care and be safe out there,

Dave