Financial Modeling - Employee Equity Options and Compensation Flashcards
What 3 types of equity based compensation?
- Stock Grants
- Restricted Stock Grants
- Employee equity options
What are stock grants?
Shares as part of compensation
What are restricted stock grants?
Shares with some restriction on their claim, usually a time period
What are employee equity options?
Options that allow employees to buy stock at a specific price over a certain period - usually also restricted to meet certain criteria.
What are 4 reasons for increasing trends in equity base compensation?
- Stockholder-manager alignment
- Scarcity of cash.
- Employee retention
- Accounting and tax treatment
What does agency theory say?
Managers accumulate too much cash, borrow too little, and make poor investment/acquisition decisions.
How do you fix the problem in agency theory?
Equity based compensation may reduce the agency problem by making managers behave more like stockholders.
Which companies have scarcity of cash?
Start-up firms don’t have cash so they offer equity based compensation
What is employee retention?
Equity compensation comes with a requirement that the employee stay with the firm for a period of time to claim the compensation
What are the advantages of equity compensation for accounting and tax?
- For accounting stock grant is a compensation expense so companies can give more than cash and report higher earnings.
- Tax laws provide tax benefits to firms that use options to reward employees.
What are the effects of “stock grants” on valuation?
Stock grants are not a problem on valuation, compensation is expensed and shares outstanding increased.
What are the effects of “employee options and restricted stock” on valuation?
- Earnings measurement is a problem - they are now expensed but imperfectly
- Shares outstanding are not adjusted; even diluted shares are not exactly right.
What are 2 effects of employee options?
- EXISTING options grants have the potential to dilute
2. Expected FUTURE option grants have the same potential and are harder to estimate.
What is option overhang?
The number of employee options outstanding as a percent of the total outstanding shares.
What 3 factors explain the use of options?
- Age and growth potential of firm
- Riskiness of firm
- Market valuation of firms (because of tax advantage)
Who uses options as compensation?
New economy does
Old economy, finance, and utilities use less.
What age and growth companies use equity compensation?
Younger companies use equity compensation because they have less cash than more mature companies.
Do safer firms or riskier firms use equity compensation?
Riskier firms use more than safer firms
Which companies get a bigger tax advantage when using options compensation?
Firms that trade at high multiple of earnings will get a much bigger tax advantage using options as compensation
What are the characteristics of option grants?
- Usually issued every year.
- Strike price is usually at the market price
- Typically long term- 10 years is the norm
- Usually a vesting period
When options are granted they must be valued using an option pricing model, what are 3 option pricing models?
- Binomial lattice
- Black-scholes
- Monte carlo simulation
For accounting of options, the value of options can be spread over what?
the vesting period
Example:Thus an option grant with estimated value of $10 million and a 5 year vesting period can be spread over the 5 years at $2 million a year.
When accounting options, if actual forfeiture rate is not equal to original estimate, how do you adjust?
Optional value is re-estimated in subsequent years and compensation cost adjusted to reflect the changes
For the accounting of options, if the option terms are modified, when do you recognize it?
The firm has to recognize the change at the time of the modification
What are the 2 options’ effect on value?
- Earnings effect
2. Dilution effect
What is the earnings effect?
Expensing of options REDUCES net income even though it’s not a cash expense
What is the dilution effect?
- Shares are sold at less than market value and shares outstanding are increased.
- Using fully diluted shares is only a rough proxy because some options will never be exercised due to employee departure and out of the money options.
How do we incorporate option compensation into DCF valuation?
- Using fully diluted shares to estimate value.
- Estimating expected option exercise in the future
- Treasury stock approach
What are 3 problems of using fully diluted shares to estimate the value?
It will lead to too low an estimate of value per share for 3 reasons:
- It considers all options outstanding, not just ones that are in the money and vested.
- It does not incorporate the expected proceeds from exercise, which will comprise a cash inflow to the firm.
- Does not build the time premium on the options into the valuation.
What are problems with estimating expected option exercise in the future?
Requires a large number of estimate and assumptions. This approach is neither practical nor useful.
What is the treasury stock approach?
Fully diluted shares are used and expected proceeds from the exercise are added to the value of equity
How do we incorporate option compensation into DCF valuation?
Estimate the value of the options today, given today’s value per share and including time premium
What is the formula
Value of equity per share = estimated value of equity - value of employee options / primary shares outsanding
What are the measurement issues in valuing employee options for vesting?
- Non vested options are worth less than vested options.
- Some options will never vest
a. some will be out the money
b. some will be forfeited if the employee leaves
What are the measurement issues in valuing employee options for illiquidity?
- Employee options are less liquid than traded options.
2. Often employee options are exercised early.
What are the measurement issues in valuing employee options for appropriate stock price to use?
- It’s counter intuitive to use current stock price because the relevant price is the value we’re trying to derive
- Circularity problem can be solved by using the Treasury stock method for current stock price in the models, then converge on proper value by iteration
What are the measurement issues in valuing employee options for TAXATION?
When options are exercised, the firm can deduct the difference between the stock price at the time and the exercise price as an employee expense
What are the measurement issues in valuing employee options for private firms?
You don’t worry about private firms.
How do you incorporate existing options into relative valuation (P/E for example)?
- Value options at fair value, and add this value to the value of equity.
- Divide by net income that has been adjusted for expensing.
- Multiply the ratio by forecast net income that has been adjusted for expensing.
- Use diluted shares.
Firms are shifting away from options to what?
Restricted stock
Although, young, risky companies will still use options, but when they get mature, they will use restricted stock for compensation,.
What are the characteristics of restricted stock
- Usually forfeited if the employee leaves within a certain period.
- Usually can not be traded for another period of time.
- Some are restricted to be granted contingent on the firm reaching a specified operating target.
What is the accounting for restricted stock?
Subtracted as a compensation cost.
How do you incorporate restricted stock into DCF valuation?
- Like options, but valuation is easier
2. When valuing restricted shares, illiquidity must be taken into account
How do you incorporate restricted stock into relative valuation?
- Already included in shares outstanding
2. Only real concern is that they should have a slightly lower value than traded shares.
