Mar 05

Employee stock options (ESOs). Investor Perspectives: Part 1

by David Harper, CFA, FRM, CIPM

CFA |

This post highlights material from our free screencast: Employee Stock Options (ESOs) from the Investor Perspective. The CFA Institute prequalified this movie tutorial for 1.0 credit hours under their Professional Development (PD) program. This five-part blog-series only highlights a few screencast concepts. Plus, the screencast applies the valuation concepts by analyzing the actual stock option grants disclosed in Yahoo's (ticker: YHOO) quarterly report (10Q). Using a spreadsheet, we compute Yahoo's option costs under a gamut of perspectives: from "quick-and-dirty" equity overhang to a more complicated net cash flow dilution. If you really want to understand the ESO valuation from an investor perspective, analyzing the downloadable spreadsheet will take you a long way.

The accounting expense is useless. This as it should be!

We start with the accounting of ESOs. Accounting standards (FASB Statement No. 123, Accounting for Stock-Based Compensation) determine the option expense (a.k.a., cost or charge) recognized on the income statement. The reported option expense reduces reported net income and earnings per share (EPS). The terms recognition and disclosure are meaningful: FAS 123R moved a footnote disclosure up into recognition on the income statement. You might say, from under the rug into the sunlight. But the accounting charge is not necessarily useful to the equity analyst. Like other items on the income statement, the true fundamental investor expects to unravel the income statement to suit his/her analytical goals.

That's part of a broader lesson about financial statements: don't take for granted items ‘as reported' on the income statement. Reported items like revenue, gross profit and net income derive from principles (the GAAP conceptual framework), standards (e.g., FAS 123R) and management discretion. None are set in cement, nor do they necessarily fit your analytical goals. Principles are not exactly timeless (e.g., there is shift underway away from reliability and toward relevance, with huge implications). Standards change and evolve. Discretion is neither bad nor something we can eliminate.  If you need to be convinced that analysts must "look under the hood" of the primary financial statements, consider how convincingly Malcolm Gladwell blames investors for Enron in Open Secrets: Enron, intelligence, and the perils of too much information by Malcolm Gladwell (the great thing about this perspective is that, using Gladwell's framework, we are reminded that financial statements are more ‘mystery' than ‘puzzle.' If they are puzzles, enough disclosure helps us get to the right valuation. If they are mysteries, we have enough information, but we need to apply "experience and insight".)

FAS 123R: Scope

The standard applies when a company awards equity to its employees. A few things about the scope:

  • It applies to equity awards (e.g., restricted stock, stock options) not for "liability awards" that call "for settlement in cash or other assets." An example of a liability award is a long-term cash plan that pays a cash bonus for hitting performance targets. The quesiton is, will the employee receive cash (a liability) or some form of equity. That's why we saw a bit of resurgent interest in certain stock appreciation rights (SARs), promoted by consultants in many cases, that try to skirt the technical scope of FAS 123R but still resemble equity awards.
  • It applies to non-employee directors but not to non-employees like third-party independent contractors.
  • It does not apply to tax-qualified Employee Stock Ownership Plans (ESOPs). Nor does it recognize the expense of the popular Employee Stock Purchase Plans (ESPPs), if the purchase discount is 5% or less.

The bottom line: the shareholder cost of long-term incentives may well extend to instruments that do not fall under the scope of FAS 123R. If you are trying to figure the dilution of incentives, you are advised to consider all long-term incentive awards.

FAS 123R: Basics

 Like other, emerging standards that try to reflect the "fair value" of an instrument, the new standard for expensing options faces a trade-off between relevance and reliability. FAS 123R prefer relevance to reliability: greater relevance ("this is a market value estimate of the cost of the options") implies less measurement reliability ("what is the objective value of this grant"). The whole of FAS 123R can be summarized in four words: grant-date fair value. Specifically, the fair value of an option award is determined on the grant date. In the case of a plain-vanilla employee stock option (i.e., granted with a strike equal to the stock price and lacking any unique performance-based characteristics), the fair value can be expressed as a percentage of the face value. For non high-tech companies, fair values on 10-year options typically fall between 20 and 50%. So, a grant of 10,000 options on a stock price of $100 (strike price also equals $100) would have a value of $300,000 if the fair value is 30% of the face value. 10,000 options x $100 stock x 30% (of face) = $300,000 fair value at grant. But, what if the options cliff-vest at the end of four years? In this typical case, the expense is spread out (amortized) over four years. So, the income statement charge is $75,000 per year over each of four years. You can see the expense is basically fixed at grant: it doesn't matter what happens to the stock price, the charge remains. The stock could sink, the options expire worthlessly, and the company still incurs the option charge. But the charge isn't entirely fixed. If some employees quit, their options may be forfeited, and those forfeited options are reversed in the future. So, for illustration's sake, assume 500 of the above options were forfeited in the fourth year. Under such a scenario, the expense charges would be: $75,000 in year 1, $75,000 in year 2, $75,000 in year 3 and $60,000 in year 4. (In the fourth year, 500 x $100×30% is reversed). So, please note: the value at grant is not reversed (in this case, $3 per option granted never changes) but the number of options is reversed.

FAS 123R: Accrual reversal

When are option awards reversed or not reversed? FASB defines three categories of vesting conditions: service, performance and market. Service vesting: Most traditional options vest according to a service (or tenure-based) condition. For example, stay employed for four years and your options vest. To the extent that actual forfeiture experience varies from the initial estimate, these forfeited shares are reversed. (But again, the value per share is not adjusted or reversed. The value per share is fixed at grant). Performance: These are fundamental performance conditions such as, common for a bank, options that vest if an ROE target is achieved. Market: Market conditions include factors that impact that exercise price or the stock price. Market conditions are not reversed: they are baked into the option valuation.  

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