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Company Valuation

Company Valuation

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2.1 Why is it important?

In many sectors, such as technology and telecommunications, the remuneration
of executives contains a significant component of stock options. These options
provide management and other employees the opportunity to participate in the
capital growth of the business. At the same time they achieve a level of goal
congruence, i.e. harmonising the objectives of management and shareholders. In
order to understand corporate performance fully, analysts must appreciate the
cost of this significant component of remuneration. If it bypasses the income
statement then this may have significant implications for comparable company
analysis as well as accurate profitability assessment. Furthermore, if a PE
approach to valuation is to be employed then the analyst needs to be aware of
how the potential dilution resulting from stock option compensation is reflected
in EPS numbers. And the same point applies to intrinsic value models; there is a
cost associated with the dilution.

2.2 What is current GAAP under IFRS for stock
options?

Accounting for employee compensation would not typically be construed as an
area of controversy or complexity. Yet recent debates have shown that achieving
a broad consensus is a significant challenge.
Essentially, there are two key accounting issues relating to stock options that
must be resolved. First, what is the compensation charge to be recognised in the
income statement? Second, what is the impact, if any, on diluted EPS?

2.2.1 The Compensation Charge

Until recently, there was no guidance on this issue under International Financial
Reporting Standards (IFRS) and very little in most national GAAPs. Therefore,
US GAAP, in the form of SFAS 123 and APB 25 Accounting for Stock Issued to
Employees
, were the appropriate reference points. There are two broad
approaches to calculating the compensation cost:

100

Company valuation under IFRS

i. Intrinsic value approach

The intrinsic value of a stock option is calculated as the difference between the
market price of the underlying and the strike price of the option.
So, if a share is trading in the market at €5 and an option offers the holder the
right to buy it for €4 then this option has an intrinsic value of €1. Options with
intrinsic value are termed in-the-money. If the right to buy (strike or exercise
price) is the same as the current market price then the option is said to be at-the-
money. If the market price is lower than the strike it is called an out-of-the-money
option. Intrinsic value can never be negative; it is simply zero. A crucial point to
note is that generally the intrinsic value is measured at grant date only.

ii. Fair value approach

The intrinsic value approach fails to recognise that options have more than
intrinsic value. Even if an option is out of the money, the price of its underlying
could rise and bring it into the money. This other element of value is termed time
value. One broadly accepted method of calculating the fair value of an option is
to use some form of Black-Scholes model, although approaches such as those
involving a binomial model (often called a ‘binomial lattice’) may also be
appropriate, especially for income-bearing assets, such as equities.

2.2.2 The International Accounting Standards Board (IASB)
response

Many hoped that the IASB would simply ignore this issue. In warning off the
IASB from considering the issue, Phil Livingston made the following comment:

‘ … we had been through 10 years of debate on this subject in the U.S.,
and were not interested in reopening the huge wounds that resulted from
the battle with the FASB … Neither side has changed its view of this issue,
and neither will. I suggested that they recognise the reality that stock
option accounting is not going to change in the U.S. Therefore, they
should get the issue off their plate and adopt a disclosure-based standard
using whatever valuation method they deem theoretically correct.’

November 2001, Financial executive

However, the IASB published IFRS 2 Share Based Payment in 2004. This
standard provides that fair values must be used for stock options. A simple
example will illustrate the approach enunciated in IFRS 2.
• Johnson plc gives 2000 options to a member of staff.
• The options have a strike price of €5. The current market price is €5.
• The options are given to the staff member in return for his services.

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Chapter Four – Key issues in accounting and their treatment under IFRS

• The vesting period is 3 years.
• A Black-Scholes model of the option would produce a fair value per option

of €3.

Number of options

2,000

Fair value (in total)

€6,000

Number of years during vesting period

3

Annual charge

€2,000

Note that in the example above, the vesting period is the period between option
grant date and the date when the option holder can actually exercise it (so called
vesting date).
As mentioned before many commentators reacted negatively to the idea of the
IASB reopening old wounds so it is no surprise that they would react negatively
to the IASB’s proposals.

2.2.3 How are options reflected in diluted EPS?

IAS 33 Earnings per Share states that the treasury stock method should be used
to reflect the dilutive element for stock options. The key point to note is that
under this approach options are only reflected if they are in-the-money. Out-of-
the-money or at-the-money options are not included at all. Therefore, there is
potential for ‘latent dilution’ and thus diluted EPS may fail to fully reflect the
dilutive potential of stock options. Given this, it is unlikely that it is an acceptable
alternative to stock option expensing.

2.3 US GAAP focus

The FASB has attempted to introduce a standard that is, for all intents and
purposes, similar to IFRS 2 discussed above.

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Company valuation under IFRS

2.4 What are the implications for financial analysis?

Some years ago US companies were given a choice of approaches to stock option
expensing; intrinsic value or fair value. Most US corporates chose the intrinsic
value approach with fair value disclosures. Presumably this is based on the fact
that it would enhance EBIT when compared to the fair value approach (fair value
is always greater than intrinsic value). European companies had typically
followed an intrinsic value approach as well. By adopting this form of treatment
companies were able to ensure that they could achieve a zero compensation
charge for the stock option component of remuneration by simply issuing stock
options at the money. For example, see the extract from CISCO’s financials in
Exhibit 4.9 below.
Irrespective of what accounting standards say, there has been no unanimity about
whether options should be expensed. However, now that companies have used
the standard in practice, the objections appear muted. To the authors the
arguments seem cogent. Options have value. If a company grants generous
options to its employees then for an investor this may make the company a less
attractive investment due to the potential future dilution. There must be a
reflection of this cost in the income statement.
A fundamental issue will be whether the user of the financials truly believes that
the expense is a real economic cost. We firmly believe it is. Once an acceptance
is made of the validity of option expensing as a concept attention must turn to the
credibility of the number itself. Naturally if one is fair valuing anything which
does not have a liquid market then there will be a significant degree of
subjectivity. In particular, certain inputs to any option valuation model, such as
volatility, tend to influence the result greatly, and yet there is no accepted
methodology for estimation. This has lead one commentator to suggest that IFRS
2 was a standard in ‘random number generation’.
However, we must bear in mind that these numbers will be audited. Audit firms
are unlikely to accept volatility and other estimates that are inconsistent with
their observations of the markets and of other clients.
Furthermore, disclosures to be made by corporations will allow users to assess
the quality of the calculation, at least to some degree.

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Chapter Four – Key issues in accounting and their treatment under IFRS

The other area of concern is that companies are free to make estimates of the
number of employees who will actually forfeit their options. The most common
form of forfeiture is the departure of the employee. Exhibit 4.8 below illustrates
how the numbers work under IFRS 2.

Exhibit 4.8: Stock option forfeit

Example 1

A corporate grants 100 share options to each of its 500 employees (50,000
options). The vesting period is three years and a binomial lattice model of the
option gives a fair value of €15. The expectation is that 20% of employees will
leave over the period and therefore the forfeiture rate is 20%. Assume these
forfeiture rates turn out to be accurate.

Year Calculation

Expense Cumulative expense

1. [50,000 X 80% X €15]X 1/3

€200,000 €200,000
2. [[50,000 X 80% X €15] X 2/3] - 200,000 €200,000 €400,000
3. [50,000 X 80% X €15] - 400,000

€200,000 €600,000

Example 2

If the forfeiture estimate changes as time progresses then the company will
make adjustments in each year to ensure the overall result is up to date on a
cumulative basis.
So the example is as above except:
• In year 1 20 people leave and the company reassesses its estimated
forfeiture rate at 15%.
• In year 2 a further 22 employees leave and the company reassesses the
forfeiture rate at 12%.
• In year 3 a further 15 employees leave meaning that over the 3 years 57
employees left.
So eventually 44,300 (443 employees at 100 options each) options vest at the
end of year 3. The relevant entries over the years would be as follows:

Year Calculation

Expense Cumulative expense

1. [50,000 X 85% X €15] X1/3

€212,500 €212,500
2. [[50,000 X 88% X €15] X 2/3] - 212,500 €227,500 €440,000
3. [50,000 X 88.6% X €15] - 440,000

€224,500 €664,5001

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Company valuation under IFRS

1 The final cumulative total of €664,500 is based on the 44,300 options at €15 each

Source: Adapted from IFRS 2 (IASB, 2004)

The key point to note is that the forfeiture rate could be used to smooth the
income statement number. For example, if a company could accelerate cost
recognition if it set a low forfeiture rate in the early periods. Alternatively costs
could be deferred if a high forfeiture rate was initially set.

2.5 Case example

As there is currently no accounting standard in Europe we do not have experience
of applying IFRS 2 until it becomes mandatory in 2005. However, we have
reproduced the policy note for Cisco below in Exhibit 4.9. It shoes that no
compensation expense arises for stock options. This will change in the future in
the EU and is expected to change in the US as well.Therefore the analyst is really
faced with estimation of the numbers that will arise as against interpretation of
the numbers that currently exist.

Exhibit 4.9: US GAAP practice – CISCO

The Company is required under Statement of Financial Accounting
Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS
123”), to disclose pro forma information regarding option grants made to
its employees based on specified valuation techniques that produce
estimated compensation charges. These amounts have not been reflected
in the Company’s Consolidated Statements of Operations because no
compensation charge arises when the price of the employees’ stock
options equals the market value of the underlying stock at the grant date,
as in the case of options granted to the Company’s employees.

Cisco published information

2.6 Building valuation models: What to do

The argument that stock options are not an expense to the business and should
therefore not be reflected in the profit and loss account is analogous to the
argument that a provision for decommissioning plant is a non-cash item and
should not be included in a discounted cash flow valuation. The latent dilution
that is likely to result from the exercise of stock options will be a cost to existing
shareholders if and when it occurs, and the challenge is to build this cost into our
valuation methodology.
It is necessary to make an important distinction here. This is between options that
have already been granted, and options that based on expectations the company
may grant in the future. Treatment of options that have already been granted is
fairly straightforward.

105

Chapter Four – Key issues in accounting and their treatment under IFRS

The more sophisticated, and more accurate, approach is to subtract the fair value
of the outstanding options from the value of the company, and then to calculate
the value of the shares by dividing the result by the number of shares currently in
issue and outstanding. In this version, the options are treated as a financial
liability, and this fully reflects their latent value.
The less sophisticated, though more common, approach is to calculate a diluted
value per share by increasing the number of shares used in the calculation to
include the dilutive options. This calculation takes into account only the in-the-
money options, and then calculates the proportion of them that are dilutive by
dividing the average exercise price by the current share price and subtracting the
result from one, to derive a percentage. The logic is that if options are exercised
at a price of 100p and the share price is 150p, then the cash raised by the exercise
would permit the company to cancel two thirds of the options, and the remaining
one third would be dilutive.
There is no doubt that the former approach is more accurate if all that we are
worried about is history, but suppose that we were confronted by a company that
was clearly likely to continue to remunerate its employees through the issue of
share options. A naïve cash flow approach to valuation would fail to pick up this
projected cost. It will appear in the profit and loss account as a non-cash cost, and
it has not yet been reflected in the grant of share options. So what do we do with
it?
The answer must be that it is an accrual that we should deduct from our forecasts
of cash flow or NOPAT in our valuation models, just like any other accrual. If we
are running a DCF model, the projected costs associated with stock options should
be left out of (i.e deducted from) the cash flows that we value, and if we are
running an economic profit model, NOPAT should be calculated after deducting
these costs. As with the treatment of other accruals, the correct treatment of stock
options is more intuitive in the framework of an economic profit analysis, but it
can be handled correctly whichever valuation approach is used.
Failure to deduct for the accrual will result in overvaluation of the company. To
see why, imagine two otherwise identical companies. One states that from now
on it will only pay its employees in cash, and raises their salaries to reflect this.
The other evidently intends to continue to pay them in a combination of cash and
stock options issued on the money, with no intrinsic value. (We assume that fair
value of the stock options brings the value of their remuneration into line with
that of the employees in the first company.) Failure to take into account the cost
associated with projected issues of new options – not just with the historical
already existing ones – will result in the second company appearing to be worth
more than the first one.

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Company valuation under IFRS

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