I prefer to use free cash flow (FCF) when valuing a company as opposed to of earnings per share. The main reason for this is that it is much more difficult to engineer a company’s FCF using funny accounting.
One of the main issues that have concerned me in calculating a company’s equity value based on FCF is how to account for the equity compensation plans to employees and management. Equity compensation plans are very rampant these days, especially in technology companies. An outside stockholder in these companies therefore has to understand how these might affect the equity value per share.
I calculate FCF as operating cash flow minus the non-discretionary capital expenditure. However, if you look at the cash flow statements provided by the company and just pick the operating cash flow number from these, you might be missing an important piece of the puzzle. This is because equity compensation which has been expensed in the income statement has been added back in calculating the operating cash flow – since this is a non-cash expense.
We may be tempted to think, "This is non-cash, so what’s the problem? There should be no effect on the FCF due to this expense, so isn’t that good for the company valuation?" Well, yes, but only to a certain extent. It is good in so far as the other stakeholders in the company are concerned. Obviously, creditors of a company will benefit if more of the employee compensation takes the form of share options or rewards – it reduces the cash-related component of the compensation and therefore leaves more cash on the table for creditor payments. This form of compensation, however, is not so good for the equity holders of the company who lose out in the form of dilution of their interests and more importantly, issuance of shares at less than the prevailing market price. If we fail to take account of this, we may end up overstating the value of equity per share.
So how do we take them into account in calculating the value of equity using FCF methods? There is a presentation by Aswath Damodaran available on the NYU Stern website which gives helpful pointers on the employee options issue (although some of it may be slightly dated now). I have tried to summarize the important points of this presentation in this article.
· The simplest way seems to be to calculate the equity value of the whole company and then to adjust the denominator for shares taking into account the dilution due to the equity compensation plans. However, this approach may result in understating the share value as it fails to take into account the cash coming into the company on the exercise of options. The extent of understatement will depend on the exercise price relative to the market price (the higher the exercise price, the more the understatement).
· The second approach is the treasury stock approach which adds the proceeds from options exercise to the company’s equity value and then divides this total by the diluted number of shares. This approach fails to take into account the time premium on the options. It also has problems with out-of-the-money options which, if considered, can reduce the value of equity per share.
· The third approach is to calculate the equity value of the company using discounted cash flow or other valuation methods and then subtract the market value or estimated market value of other equity claims (warrants, convertibles, etc.). This number then needs to be divided by the number of outstanding shares to get the value per share. The value of the options can be calculated using the option pricing models.
This seems a lot of work for the private outside investor – fortunately, the company already calculates the value of options in the accounts and this number can then be used for this calculation (adjusting for the tax benefit).
Obviously, the company may continue to grant equity awards in the future as well. These will affect the value and need to be considered for our analysis. The easiest way to deal with this is to look at the options granted over the past few years as a percent of revenues. Then using this percentage, estimate the option grants in future years and consider this as part of operating expenses. The operating income and cash flow will be reduced to that effect. We can then use these revised cash flows in our valuation.
The issue of share options is particularly relevant in relative valuations where companies are compared on the basis of multiple of cash flows, especially if the cash flows have not been adjusted for equity-related compensation. Assume both company A and B have $100 FCF. Company A, however, has added back $10 for equity related non-cash compensation in arriving at its FCF. Company B has no equity-related compensation. In this case it will be incorrect to attribute the same multiple to both companies (assuming all other things are equal).
Options outstanding as a percent of outstanding stock can also be used as a qualitative variable, i.e. we can apply a further discount to the equity value of firms with more options outstanding.
Disclosure: None
Disclaimer
This research was produced by M. Joshi (the “Author”). Information and opinions presented in this research have been obtained or derived from sources believed to be reliable, but the Author makes no representation as to their accuracy or completeness. The Author accepts no liability for loss arising from the use of the material presented in this report. The Author may have long or short positions in (please refer to the Disclosure above), or may buy or sell any of the securities, derivative instruments or other investments mentioned or described in this research, either as agent or as principal for their own account. This research is prepared solely for information purposes and it does not constitute an advertisement. This document is not, and must not be construed as, a solicitation or an offer to buy or sell any securities or other financial instruments in any jurisdiction. By writing this research, the Author neither provides personal recommendations to, nor receives and transmits orders from, nor executes orders for, recipients of this research. This research should neither be passed on, nor reproduced in whole or in part under any circumstances without the Author’s express consent. This report is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation which would subject the Author to any registration or licensing requirement within such jurisdiction. The financial instruments described in this research may not be eligible for sale in all jurisdictions or to certain categories of investors.
One of the main issues that have concerned me in calculating a company’s equity value based on FCF is how to account for the equity compensation plans to employees and management. Equity compensation plans are very rampant these days, especially in technology companies. An outside stockholder in these companies therefore has to understand how these might affect the equity value per share.
I calculate FCF as operating cash flow minus the non-discretionary capital expenditure. However, if you look at the cash flow statements provided by the company and just pick the operating cash flow number from these, you might be missing an important piece of the puzzle. This is because equity compensation which has been expensed in the income statement has been added back in calculating the operating cash flow – since this is a non-cash expense.
We may be tempted to think, "This is non-cash, so what’s the problem? There should be no effect on the FCF due to this expense, so isn’t that good for the company valuation?" Well, yes, but only to a certain extent. It is good in so far as the other stakeholders in the company are concerned. Obviously, creditors of a company will benefit if more of the employee compensation takes the form of share options or rewards – it reduces the cash-related component of the compensation and therefore leaves more cash on the table for creditor payments. This form of compensation, however, is not so good for the equity holders of the company who lose out in the form of dilution of their interests and more importantly, issuance of shares at less than the prevailing market price. If we fail to take account of this, we may end up overstating the value of equity per share.
So how do we take them into account in calculating the value of equity using FCF methods? There is a presentation by Aswath Damodaran available on the NYU Stern website which gives helpful pointers on the employee options issue (although some of it may be slightly dated now). I have tried to summarize the important points of this presentation in this article.
· The simplest way seems to be to calculate the equity value of the whole company and then to adjust the denominator for shares taking into account the dilution due to the equity compensation plans. However, this approach may result in understating the share value as it fails to take into account the cash coming into the company on the exercise of options. The extent of understatement will depend on the exercise price relative to the market price (the higher the exercise price, the more the understatement).
· The second approach is the treasury stock approach which adds the proceeds from options exercise to the company’s equity value and then divides this total by the diluted number of shares. This approach fails to take into account the time premium on the options. It also has problems with out-of-the-money options which, if considered, can reduce the value of equity per share.
· The third approach is to calculate the equity value of the company using discounted cash flow or other valuation methods and then subtract the market value or estimated market value of other equity claims (warrants, convertibles, etc.). This number then needs to be divided by the number of outstanding shares to get the value per share. The value of the options can be calculated using the option pricing models.
This seems a lot of work for the private outside investor – fortunately, the company already calculates the value of options in the accounts and this number can then be used for this calculation (adjusting for the tax benefit).
Obviously, the company may continue to grant equity awards in the future as well. These will affect the value and need to be considered for our analysis. The easiest way to deal with this is to look at the options granted over the past few years as a percent of revenues. Then using this percentage, estimate the option grants in future years and consider this as part of operating expenses. The operating income and cash flow will be reduced to that effect. We can then use these revised cash flows in our valuation.
The issue of share options is particularly relevant in relative valuations where companies are compared on the basis of multiple of cash flows, especially if the cash flows have not been adjusted for equity-related compensation. Assume both company A and B have $100 FCF. Company A, however, has added back $10 for equity related non-cash compensation in arriving at its FCF. Company B has no equity-related compensation. In this case it will be incorrect to attribute the same multiple to both companies (assuming all other things are equal).
Options outstanding as a percent of outstanding stock can also be used as a qualitative variable, i.e. we can apply a further discount to the equity value of firms with more options outstanding.
Disclosure: None
Disclaimer
This research was produced by M. Joshi (the “Author”). Information and opinions presented in this research have been obtained or derived from sources believed to be reliable, but the Author makes no representation as to their accuracy or completeness. The Author accepts no liability for loss arising from the use of the material presented in this report. The Author may have long or short positions in (please refer to the Disclosure above), or may buy or sell any of the securities, derivative instruments or other investments mentioned or described in this research, either as agent or as principal for their own account. This research is prepared solely for information purposes and it does not constitute an advertisement. This document is not, and must not be construed as, a solicitation or an offer to buy or sell any securities or other financial instruments in any jurisdiction. By writing this research, the Author neither provides personal recommendations to, nor receives and transmits orders from, nor executes orders for, recipients of this research. This research should neither be passed on, nor reproduced in whole or in part under any circumstances without the Author’s express consent. This report is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation which would subject the Author to any registration or licensing requirement within such jurisdiction. The financial instruments described in this research may not be eligible for sale in all jurisdictions or to certain categories of investors.
