Mar 09

Employee stock options (ESOs). Investor Perspectives: Part 5

by David Harper, CFA, FRM, CIPM

CFA |

This post is the fifth and final (5th of 5 total) in a series that highlights material from our free screencast tutorial called Employee Stock Options (ESOs) from the Investor Perspective. The CFA Institute prequalified the tutorial for 1.0 credit hours under their Professional Development (PD) program. In the screencast, we use Yahoo's (YHOO) quarterly reported data to analyze FAS 123R, diluted EPS (FAS 128), compute equity overhang (potential dilution), economic dilution, and net cash flow. That runs the gamut in the hierarchy from simple but inaccurate (the FAS 123R reported option expense) to complex but accurate (net cash flow). Also, employee stock option dilution can be either incorporated into the summary valuation (see green bubbles below) or offered as a standalone metric (see orange bubble).

Net Cash Flow

In this sophisticated approach, we start with the 'as reported' statement of cash flows and make adjustments to more accurately reflect the cash flow impact of ESOs. The bottom line on the statement of cash flows is net cash flow, but this net cash flow classified into three different buckets: operating, investing, and financing. (If you'd like to understand this in more detail, we have a more tutorial on Statement of Cash Flows). Option-related cash flow items can be found under both cash flow from Operating Activities (CFO) and cash flow from financing activities (CFF):

Cash flows from Operating (CFO)

  • Stock-based compensation expense (+)
  • Tax benefits from stock-based compensation (+)
  • Excess tax benefits from stock-based compensation (-)

Cash flows from Financing (CFF)

  • Proceeds from issuance of common stock, net (+)
  • Repurchase of common stock (-)
  • Excess tax benefits from stock-based compensation (+)

Please note the sign (+/-) indicates the direction of the cash flow in Yahoo's case: positive (+) indicates a source of cash flow, or cash inflow. Negative indicates a use of cash, or cash outflow. For example, the repurchase of common stock is always going to be negative (-): it is a cash outflow or 'use of cash.' The stock repurchase is also the only item here not directly related to ESOs; that is, a company conducts none/some/all of its stock repurchase program independently of the ESO program. But, in Yahoo's case, as with most technology companies, a big part of the repurchase is meant to offset ESO dilution.

1. Estimate present value of net cash flow cost of the ESO grant

The net cash flow approach has two big steps:

  1. We estimate the present value of the net cash flow cost of periodic ESO grants;
  2. We replace 'as reported' cash flow items with our own estimates

For the first step, in Yahoo's case, we prospectively estimated a 2% run-rate over a six-month period (a.k.a., burn-rate). That means we project a 4% annual run-rate: we think Yahoo will grant options on 4% of outstanding shares. We also estimated a present value (PV) net cash flow cost per option of $7.39 (see below):

That gave us a present value (PV) estimate of about $209 million. You'll note in the screencast that it's important to reduce the cost by the tax benefit. The company's tax bill is reduced by option exercises; this is a real cash inflow that significantly reduces the cash flow cost of ESOs.

2. Reverse reported items (eliminate ESO impacts) and insert our own estimate 

Then we made six adjustments (reversals) in the statement of cash flows. In cash from operating activities (CFO), we did the following:

  • Reverse the reported stock-based compensation expense
  • Reverse the tax benefits from stock-based compensation expense
  • Reverse the Excess tax benefits from from stock-based compensation expense

In effect, we've eliminated any ESO impact on operating cash flows.

In regard to cash from financing (CFF) activities, we did the following:

  • Reversed proceeds from issuance of common stock
  • Reversed repurchases
  • Reversed excess tax benefits from stock-based compensation

Two notes: 1. We do a real simple thing by reversing all of the repurchase. In doing so, we're assuming that the entire repurchase is used to offset (pay for) ESO dilution. That may overstate, so it would be okay to use a lesser amount. 2. Note the excess tax benefit is the same as found under CFO, but in a different direction (i.e., as reported, the excess tax benefit is negative in CFO and positive in CFF). That's due to a recent accounting change: the cash tax benefit from stock-based compensation will typically be split between operating cash flows (CFO) and financing cash flows (CFF). The "excess" is the difference between what the company booked (estimated) and the actual tax benefit. So, for example, if they under-booked, the excess will be positive and show up in CFF.

Okay, so with six adjustments we have eliminated the impact of ESOs from the statement of cash flows. Our final step is to insert our own present value, net cash flow estimate of about $209 million. In the screencast, that's all we did: after boosting net cash flow by making the above reversals, we then reduced it by $209 million to arrive at our own improved estimate of net cash flow.

I hope that has been helpful, please write me and let me know if you have questions. Thank you!

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