Valuation: Management Options, Control,and Liquidity
- Management and Employee Options
- Value of Control
- Value of Liquidity
- Summary
This chapter is from the book
This chapter is from the book
This chapter is from the book
Once you have valued the equity in a firm, it may appear to be a relatively simple exercise to estimate the value per share. All it seems you need to do is divide the value of the equity by the number of shares outstanding. But, in the case of technology firms, even this simple exercise can become com-plicated by the presence of management and employee options. In this chapter, we begin by considering the magnitude of this option overhang on valuation and then consider ways of incorporating the effect into the value per share.
We also consider two other issues that may be of relevance, especially when valuing smaller technology firms or private businesses. The first issue is the concentration of shares in the hands of the owner/managers of these firms and the consequences for stockholder power and control. This effect is intensified when a firm has shares with different voting rights.
The second issue is the effect of illiquidity. When investors in a firm's stock or equity cannot easily liquidate their positions, the lack of liquidity can affect value. This can become an issue, not only when you are valuing private firms, but also when valuing mall publicly traded firms with relatively few shares traded.
Management and Employee Options
Firms use options to reward managers as well as other employees. These options have two effects on value per share. One is created by options that have already been granted. These options reduce the value of equity per share, since a portion of the existing equity in the firm has to be set aside to meet these eventual option exercises. The other is the likelihood that these firms will continue to use options to reward employees or to compensate them. These expected option grants reduce the portion of the expected future cash flows that accrue to existing stockholders.
The Magnitude of the Option Overhang
The use of options in management compensation packages is not new to technology firms. Many firms in the 1970s and 1980s initiated option-based compensation packages to induce top managers to think like stockholders in their decision making. What is different about technology firms? One difference is that management contracts at these firms are much more heavily weighted toward options than are those at other firms. The second difference is that the paucity of cash at these firms has meant that options are granted not just to top managers but to employees all through the organization, making the total option grants much larger. The third difference is that some of the smaller firms have used options to meet operating expenses and to pay for supplies.
Figure 7–1 summarizes the number of options outstanding as a percent of outstanding stock at technology firms and com-pares them to options outstanding at nontechnology firms.
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As Figure 7–1 makes clear, the overhang is larger for younger new technology firms. In Figure 7–2, the number of options as a percent of outstanding stock at Amazon, Ariba, Cisco, Motorola, and Rediff.com are reported.
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FIGURE 7–1 Options as Percent of Outstanding Stock (Source: Morningstar, www.morningstar.com, June 7, 2000, Morningstar, Inc.)
Rediff.com has no options outstanding, but the other four firms have options outstanding. Amazon, in particular, has options on 80.34 million shares, representing more than 22% of the actual shares outstanding at the firm (351.77 million). Motorola, reflecting its status as an older and more mature firm, has far fewer options outstanding, relative to the number of outstanding shares.
Firms that use employee options usually restrict when and whether these options can be exercised. It is standard, for instance, that the options granted to an employee cannot be exercised until they are vested. For vesting to occur, the employee usually has to remain for a period that is specified in a contract. Firms do this to keep employee turnover low, but the practice also has implications for option valuation, as we examine later. Firms that issue options do not face any tax consequences in the year in which they make the issue. When the options are exercised, however, firms are allowed to treat the difference between the stock price and the exercise price as an employee expense. This tax deductibility also has implications for option value.
FIGURE 7–2 Options Outstanding as Percent Shares Outstanding
ILLUSTRATION 7.1
Options Outstanding
Table 7.1 summarizes the number of options outstanding at each of the firms that we are valuing, with the average exercise price and maturity of the options, as well as the percent of the options that are vested in each firm.
TABLE 7.1 Options Outstanding
|
|
Amazon |
Ariba |
Cisco |
Motorola |
Rediff.com |
|
Number of options outstanding |
80.34 |
20.675 |
439.00 |
36.98 |
0 |
|
Average exercise price |
$27.76 |
$6.77 |
$22.52 |
$46.00 |
NA |
|
Average maturity |
9.00 |
9.31 |
6.80 |
6.20 |
NA |
|
% vested |
58% |
61% |
71% |
75% |
NA |
While Amazon has far more options outstanding as a percent of the outstanding stock, Ariba's options have a much lower exercise price, on average. In fact, Ariba's stock price of $75 at the time of this analysis was almost eight times the average exercise price of $6.77. The average maturity of the options at all of these firms is also in excess of six years for Cisco and Motorola, and in excess of nine years for Amazon and Ariba. 1 The combination of a low exercise price and long maturity make the options issued by these firms very valuable. Fewer of Amazon and Ariba's options are vested, reflecting the fact that these are younger firms which have granted more of these options recently.
Options in Existence
Given the large number of options outstanding at many technology firms, your first task is to consider ways in which you can incorporate their effect into value per share. The section begins by presenting the argument for why these out-standing options matter when computing value per share and then considers four ways in which you can incorporate their effect on value.
Why Options Affect Value per Share.Why do existing options affect value per share? Note that not all options do. In fact, options issued and listed by the options exchanges have no effect on the value per share of the firms on which they are issued. The options issued by firms do have an effect on value per share, since there is a chance that they will be exercised in the near or far future. Given that these options offer the right to individuals to buy stock at a fixed price, they will be exercised only if the stock price rises above that exercise price. When they are exercised, the firm has two choices, both of which have negative consequences for existing stockholders. The
firm can issue additional shares to cover the option exercise. But this increases the number of shares outstanding and reduces the value per share to existing stockholders. 2 Alternatively, the firm can use cash flows from operations to buy back shares in the open market and use these shares to meet the option exercise. This approach reduces the cash flows available to current equity investors in future periods and makes their equity less valuable today.
Ways of Incorporating Existing Options into Value Four approaches are used to incorporate the effect of options that are already out-standing into the value per share. However, the first three approaches can lead to misleading estimates of value.
Use fully diluted number of shares to estimate per-share value. The simplest way to incorporate the effect of outstanding options on value per share is to divide the value of equity by the number of shares that will be outstanding if all options are exercised today—the fully diluted number of shares. While this approach has the virtue of simplicity, it will lead to too low an estimate of value per share for two reasons:
It considers all options outstanding, not just ones that are in the money and vested. To be fair, there are variants of this approach where the shares outstanding are adjusted to reflect only in-the-money and vested options.
It does not incorporate the expected proceeds from exercise, which will comprise a cash inflow to the firm.
Finally, this approach does not build in the time premium on the options into the valuation either.
ILLUSTRATION 7.2
Fully Diluted Approach to Estimating Value per Share
To apply the fully diluted approach to estimate the per-share value, use the equity values estimated in Chapter 6, "Estimating Firm Value," for each firm in conjunction with the number of shares outstanding, including those underlying the options. Table 7.2 summarizes the value per share derived from this approach.
TABLE 7.2 Fully Diluted Approach to Estimating Value per Share
Amazon
Ariba
Cisco
Motorola
Rediff.com
Value of equity
$13,589
$17,941
$318,336
$69,957
$474
Primary shares
351.77
235.8
6890
2152
24.9
Fully diluted shares
432.11
256.475
7329
2188.98
24.9
Value per share (primary)
$38.63
$76.08
$46.20
$32.51
$19.05
Value per share (fully diluted)
$31.45
$69.95
$43.44
$31.96
$19.05
The value per share from the fully diluted approach is significantly lower than the value per share from the primary shares outstanding. This value, however, ignores both the proceeds from the exercise of the options as well as the time value inherent in the options.
Estimate expected option exercises in the future and build in expected dilution. In this approach, you forecast when in the future the options will be exercised and build in the expected cash outflows associated with the exercise, by assuming that the firm will buy back stock to cover the exercise. The biggest limitation of this approach is that it requires estimates of what the stock price will be in the future and when options will be exercised on the stock. Given that your objective is to examine whether the price today is correct, forecasting future prices to estimate the current value per share seems circular. In general, this approach is neither practical nor particularly useful for reasonable estimates of value.
Adjust for outstanding options, but add proceeds to equity. This approach, called the Treasury Stock approach, is a variant of the fully diluted approach. Here, the number of shares is adjusted to reflect options that are outstanding, but the expected proceeds from the exercise (exercise price x number of options) are added to the value of equity. The limitations of this approach are that, like the fully diluted approach, it does not consider the time premium on the options and there is no effective way of dealing with vesting. Generally, this approach, by underestimating the value of options granted, will overestimate the value of equity per share.
The biggest advantage of this approach is that it does not require a value per share (or stock price) to incorporate the option value into per-share value. As you will see with the last (and recommended) approach, a circularity is created when the stock price is input into the estimation of value per share.
ILLUSTRATION 7.3
Treasury Stock Approach
In Table 7.3, we estimate the value per share by using the treasury stock approach for Amazon, Ariba, Cisco, Motorola, and Rediff.com.
Note that the value per share from this approach is higher than the value per share from the fully diluted approach for each of the companies with options outstanding. The difference is greatest for Amazon because the options have a higher exercise price, relative to the current stock price. The estimated value per share still ignores the time value of the options.
TABLE 7.3 Value of Equity per Share: Treasury Stock Approach
Amazon
Ariba
Cisco
Motorola
Rediff.com
Number of options outstanding
80.34
20.675
439
36.98
0
Average exercise price
$27.76
$6.77
$22.52
$46.00
$0.00
Proceeds from exercise
$2,229.84
$139.97
$9,886.28
$1,701.08
$0.00
Value of equity
$13,588.61
$17,940.64
$318,335.78
$69,956.97
$474.37
+ Proceeds from exercise
$2,229.84
$139.97
$9,886.28
$1,701.08
$0.00
Total value
$15,818.45
$18,080.61
$328,222.06
$71,658.05
$474.37
Fully diluted number of shares
432.11
256.475
7329
2188.98
24.9
Value per share
$36.61
$70.50
$44.78
$32.74
$19.05
Value options by using an option pricing model. The correct approach to dealing with options is to estimate the value of the options today, given today's value per share and the time premium on the option. Once this value has been estimated, it is subtracted from the equity value and divided by the number of shares outstanding to arrive at value per share.
Value of Equity per Share = (Value of Equity – Value of Options Outstanding) / Primary Number of Shares OutstandingIn valuing these options, however, you confront four measurement issues.
Vesting. Not all of the options outstanding are vested, and some of the nonvested options might never be exercised.
Stock price. The stock price to use in valuing these options is debatable. The value per share is an input to the process as well as the output of the process.
Taxation. Since firms are allowed to deduct a portion of the expense associated with option exercises, there may be a potential tax savings when the options are exercised.
Nontraded firms. Key inputs to the option pricing model, including the stock price and the variance, cannot be obtained for private firms or firms on the verge of a public offering, like Rediff.com. The options must nevertheless be valued.
These options are discussed in more detail below.
Dealing with vesting: Recall that firms granting employee options usually require that the employee receiving the options stay with the firm for a specified period, for the option to be vested. Consequently, when you examine the options outstanding at a firm, you are looking at a mix of vested and nonvested options. The nonvested options should be worth less than the vested options, but the probability of vesting will depend on how in-the-money the options are and the period left for an employee to vest. While there have been attempts 3 to develop option pricing models that allow for the possibility that employees may leave a firm before vesting and forfeit the value of their options, the likelihood of such an occurrence when a manager's holdings are substantial should be small. Carpenter (1998) developed a simple extension of the standard option pricing model to allow for early exercise and forfeiture and used it to value executive options.
Arriving at a stock price to use: The answer to which stock price to use may seem obvious. Since the stock is traded and you can obtain a stock price, it would seem that you should be using the current stock price to value options. However, you are valuing these options to arrive at a value per share that you will then compare to the market price to decide whether a stock is under- or overvalued. Thus, it seems inconsistent to use the current market price to arrive at the value of the options and then use this option value to estimate an entirely different value per share.
There is a solution. You can value the options by using the estimated value per share. Doing so creates circular reasoning in your valuation. In other words, you need the option value to estimate value per share and value per share to estimate the option value. We would recommend that the value per share be initially estimated by the treasury stock approach and that you then converge on the proper value per share by iterating.4
There is another related issue. When options are exercised, they increase the number of shares outstanding, and by doing so, they can have an effect on the stock price. In conventional option pricing models, the exercise of the option does not affect the stock price. These models must be adapted to allow for the dilutive effect of option exercise. We examine how option-pricing models can be modified to allow for dilution in Chapter 11, "Real Options in Valuation."
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, for tax purposes. This potential tax benefit reduces the drain on value created by having options outstanding. One way in which you could estimate the tax benefit is to multiply the difference between the stock price today and the exercise price by the tax rate; clearly, this would make sense only if the options are in-the-money. Although this approach does not allow for the expected price appreciation over time, it has the benefit of simplicity. An alternative way of estimating the tax benefit is to compute the after-tax value of the options:
Nontraded firms: A couple of key inputs to the option pricing model—the current price per share and the variance in stock prices—cannot be obtained if a firm is not publicly traded. There are two choices in this case. One is to revert to the treasury stock approach to estimate the value of the options outstanding and abandon the option pricing models. The other choice is to stay with the option pricing models and to estimate the value per share from the discounted cash flow model. The variance of similar firms that are publicly traded can be used to estimate the value of the options.
After-Tax Value of Options = Value from Option Pricing Model (1 – Tax Rat e)
This approach is also straightforward and allows you to consider the tax benefits from option exercise in valuation. One of the advantages of this approach is that you can use it to consider the potential tax benefit even when options are out-of-the-money.
ILLUSTRATION 7.4
Option Value Approach
In Table 7.4, we begin by estimating the value of the options outstanding, using a modified option pricing model that allows for dilution.5 To estimate the value of the options, we first estimate the standard deviation in stock prices6 over the previous two years. Weekly returns are used to make the estimate, and the estimate is annualized.7 All options, vested as well as nonvested, are valued and there is no adjustment for nonvesting.
In estimating the after-tax value of the options at Amazon and Ariba, we have used their prospective marginal tax rate of 35%. If the options are exercised prior to these firms reaching their marginal tax rates, the tax benefit is lower since the expenses are carried forward and offset against income in future periods.
You can now calculate the value per share by subtracting the value of the options outstanding from the value of equity and dividing by the primary number of shares outstanding, as in Table 7.5.
The inconsistency referred to earlier is clear when you compare the value per share estimated in Table 7.5 to the price per share used in Table 7.4 to estimate the value of the options. For instance, Amazon's value per share is $32.33, whereas the price per share used in the option valuation is $49. If you choose to iterate, you would revalue the options by using the estimated value of $32.33, which would lower the value of the options and increase the value per share, leading to a second iteration and a third one, and so on. The values converge to yield a consistent estimate. The consistent estimates of value are provided in Table 7.6.
For Motorola and Ariba, the difference in value from iterating is negligible, since the value per share that we estimated for the firms is close to the current stock price. For Cisco, the value of the options drops by almost 40%, but the overall effect on value is muted because the number of options outstanding as a percent of outstanding stock is small. The difference in values is greatest at Amazon, for two reasons. First, the value per share was significantly lower than the current price at the time of the valuation. Second, Amazon had the highest value for options outstanding as a percent of stock outstanding.
TABLE 7.4 Estimated Value of Options Outstanding
Option Pricing Model
Amazon
Ariba
Cisco
Motorola
Rediff.com
Number of options outstanding
80.34
20.675
439
36.98
0
Average exercise price
$27.76
$6.77
$22.52
$46.00
$0.00
Estimated standard deviation (volatility)
85%
80%
40%
34%
80%
Stock price at time of analysis
$49.00
$75.63
$64.88
$34.25
$10.00
Value per option
$42.44
$72.92
$50.13
$11.75
$8.68
Value of options outstanding
$3,409.67
$1,508.00
$22,008.00
$435.00
$0.00
Tax rate
35.00%
35.00%
35.00%
35.00%
38.50%
After-tax value of options outstanding
$2,216
$980.00
$14,305.00
$283.00
$0.00
TABLE 7.5 Value of Equity per Share
Amazon
Ariba
Cisco
Motorola
Rediff.com
Value of equity
$13,588.61
$17,940.64
$318,335.78
$69,956.97
$474.37
– Value of options outstanding
$2,216.00
$980.00
$14,305.00
$283.00
$0.00
Value of equity in shares outstanding
$11,372.32
$16,960.71
$304,030.58
$69,674.46
$474.37
Primary shares outstanding
351.77
235.8
6890
2152
24.9
Value per share
$32.33
$71.93
$44.13
$32.38
$19.05
TABLE 7.6 Consistent Estimates of Value per Share
Amazon
Ariba
Cisco
Motorola
Rediff.com
Value of options (with current stock price)
$2,216.00
$980.00
$14,305.00
$282.51
$0.00
Value per share
$32.33
$71.93
$44.13
$32.38
$19.05
Value of options (with iterated value)
$1,500.00
$933.00
$8,861.00
$282.51
$0.00
Value per share
$34.37
$72.13
$44.92
$32.38
$19.05
Future Option Grants
While incorporating options that are already outstanding is fairly straightforward, incorporating the effects of future option grants is much more complicated. In this section, we examine the argument for why these option issues affect value and discuss how to incorporate these effects into value.
Why Future Options Issues Affect Value. Just as outstanding options represent potential dilution or cash outflows to existing equity investors, expected option grants in the future will affect value per share by increasing the number of shares outstanding in future periods. The simplest way of thinking about this expected dilution is to consider the terminal value in the discounted cash flow model. As constructed in the last chapter, the terminal value is discounted to the present and divided by the shares outstanding today to arrive at the value per share. However, expected option issues in the future will increase the number of shares outstanding in the terminal year and there-fore reduce the portion of the terminal value that belongs to existing equity investors.
Ways of Incorporating Effect into Value per Share It is much more difficult to incorporate the effect of expected option issues into value than existing options outstanding. The reason is that you have to forecast not only how many options will be issued by a firm in future periods but also what the terms of these options will be. While this forecasting may be possible for a couple of periods with proprietary information (the firm lets you know how much it plans to issue and at what terms), it will become more difficult in circumstances beyond that point. Below, we consider a way in which to obtain an estimate of the option value and look at two ways of dealing with this estimate, once obtained.
Estimate Option Value as an Operating or Capital Expense You can estimate the value of options that will be granted in future periods as a percentage of revenues or operating income. By doing so, you avoid the need to estimate the number and terms of future option issues. Estimation will also become easier because you can draw on the firm's own history (by looking at the value of option grants in previous years as a proportion of revenues) and the experiences of more mature firms in the sector. Generally, as firms become larger, the value of options granted as a percent of revenues should become smaller.
Having estimated the value of expected future option issues, you are left with another choice. You can consider this value each period as an operating expense and compute the operating income after the expense. You are assuming, then, that option issues form part of annual compensation. Alternatively, you can treat this value as a capital expense and amortize it over multiple periods. While the cash flow in each period is unaffected by this distinction, it has consequences for the return on capital and reinvestment rates that you mea-sure for a firm.
It is important that you do not double-count future option issues. The current operating expenses of the firm already include the expenses associated with option exercises in the current period. The operating margins and returns on capital that you might derive by looking at industry averages reflect the effects of option exercise in the current period for the firms in the industry. If the effect on operating income of option exercise in the current period is less than the expected value of new option issues, you have to allow for an additional expense associated with option issues. Conversely, if a disproportionately large number of options were exercised in the last period, you have to reduce the operating expenses to allow for the fact that the expected effect of option issues in future periods will be smaller.
ILLUSTRATION 7.5
Valuing with Expected Option Issues
In all of the valuations you have seen so far, the current operating income and the industry averages were key inputs. The current operating income was used to compute the current return on capital, margin, and reinvestment rate for the firm. The industry average margins or returns on capital were used to estimate the stable growth inputs.
The current operating income reflects the effects of options exercised over the last period but not the effect of new options issued. To the extent that the latter is greater (or lower) than the former, the operating income, margins, and returns on capital have been overstated (or understated). To illustrate the adjustment, we consider the number of options issued and the number exercised at Amazon and Cisco during the last year, summarized in Table 7.7, and the exercise prices of each.
TABLE 7.7 Options Issued and Exercised: Amazon and Cisco
Amazon
Cisco
Number
Exercise Price
Value
Number
Exercise Price
Value
Options granted
31.739
$63.60
$1,273
107
$49.58
$4,589
Options canceled
11.281
$3.86
—
10
$24.66
$0
Options exercised
16.125
$19.70
$472
93
$6.85
$5,396
Effect on operating income
–$809
+$807
The values of the option grants are estimated with the option pricing model,8 whereas the value of the options exercised is the exercise value—the difference between the stock price and the exercise price. For Amazon, the value of the options granted was significantly higher than the value of the exercised options. Consequently, its operating loss would have been even greater (by $809 million) than was estimated in Chapter 4 if the difference between the exercise value and the new options granted is considered an additional employee expense. For Cisco, on the other hand, the value of the options exercised exceeded the value of the options granted. The difference between the two (of $807 million) should be added to operating income to arrive at the corrected operating income. Similar adjustments can be made to the operating income at Ariba and Motorola; Ariba's operating income would have been $246 million lower with the adjustment, and Motorola's would have increased by $14 million.
The industry-average returns on capital and margins are more difficult to adjust. You would have to make the adjustment described above to every firm in the industry and compute returns on capital and margins after the adjustment. For simplicity, the value of options exercised is assumed to be equal to the value of options issued in the current period for the industry.
Table 7.8 reports on the adjustment to current operating income and the final values per share that emerge as a result of this adjustment.
TABLE 7.8 Values per Share with Option Adjustment to Current Operating Income
Amazon
Ariba
Cisco
Motorola
Unadjusted operating income
$(276.00)
$(163.70)
$3,455.00
$3,216.00
Value per share (no option adjustment)
$32.33
$71.93
$44.13
$32.38
Adjusted operating income
$(1,076.29)
$(409.00)
$4,262.00
$3,230.00
Value (option grant adjustment)
$26.62
$58.80
$53.04
$32.48
The effect of the adjustment is trivial at Motorola. The value per share is lower than the original estimates at Amazon and Ariba, reflecting the drain on value per share that options will continue to be in future years. The value per share is higher at Cisco because of the increase in operating income created by the adjustment.
Estimate Expected Stock Price Dilution from Option Issues. The other way of dealing with expected option grants in the future is to build in the expected dilution that will result from these option issues. To do so, you have to make a simplifying assumption. For instance, you could assume that options issued will represent a fixed percent of the outstanding stock each period and base this estimate on the firm's history or on the experience of more mature firms in the sector. Generally, this approach is more complicated than the first one and does not lead to a more precise estimate of value. Clearly, it would be inappropriate to do both: show option issues as an expense and allow for the dilution that will occur from the issue. That double-counts the same cost.