Financial Statement Analysis & Valuation Chapter 8 – Microsoft Case Analysis of Shareholder Equity
Financial Statement Analysis & Valuation
Chapter 8 – Microsoft Case
Analysis of Shareholder Equity
BACKGROUND
‘Most successful Software firm ever’
Between 1994 and 2000,
Revenue grew by more than 700%
Earnings grew by more than 1200%
Peak of Dotcom Bubble (Between 1998 and 2000):
Stock price rose from $36 to $120 per share
Trailing P/E ratio went as high as 66
Has significant ‘Knowledge Capital’
Stock Options used to attract leading talent
GAAP Accounting does not report this cost nor even significant
off-balance sheet liabilities to pay for the knowledge
QUESTIONS TO TACKLE
Cash paid to shareholders
Comprehensive Income
Issues with Comprehensive Income
GAAP Reporting & Put Options
Reversal of Dilution
Loss to shareholders from employees
Correct treatment of tax benefit accounting
Quality of reported income
Issues in valuing shares due to stock options treatment
1. CASH PAID TO SHAREHOLDERS
Cash Transactions with Shareholders (Amount in Millions)
Common Stock Issued $ 1750
Common Stock Repurchased ($4872)
Net Cash Paid to Shareholders $ 3122
Working Backwards:
Cash Transactions with Shareholders (Amount in Millions)
Common Stock Repurchased ($ 186.00)
($
4872)
($ 4686)
Common Stock Issued $ 2843.00
Preferred Stock converted to common stock $ 1093
Net proceeds on issue of common stock $ 1750
Net Cash Paid to Shareholders $ 3122
$980 given in
case, $113
difference
2. COMPREHENSIVE INCOME
Comprehensive Income
Net Income $ 7012.00
Other Comprehensive Income
Net unrealized investment gains $ 2724.00
Translation adjustments and other $ 166.00
Preferred dividends $ (13.00)
$ 9889.00
2. REFORMULATED STATEMENT
Beginning Equity $ 27,458.00
Transactions with Shareholders
Common stock issued $ 2843.00
Proceeds from sale of put warrants $ 472.00
Tax benefit from stock option exercise $ 4002.00
Common stock repurchased $ (4872.00)
$ 2445.00
Comprehensive Income
Net Income $ 7012.00
Other Comprehensive Income
Net unrealized investment gains $ 2724.00
Translation adjustments and other $ 166.00
Preferred dividends $ (13.00)
$ 9889.00
Ending Equity $ 39,792.00
3. COMPREHENSIVE INCOME - ISSUES
Stock Option loss : Tax benefit = $ 4.002 bn
Stock based compensation expense and related tax benefit
would affect the operating income
Option overhang of After tax Stock Option Loss is an off-
balance sheet item
Preferred Stock converted to Common Stock
Conversion @ $77 per share whereas market price of $93
Loss on conversion to common stock is recognized in
income statement
Sale of put warrants – Stock options are contingent liabilities
Premium should be recognized as liability
Change in valuation of liability (or warrant ) is recorded as
loss (gain) in income statement
Comprehensive Income should include Gains or Losses on changes in the value
of put warrants and stock based compensation expense net of tax benefits.
4. EXERCISE OF PUT OPTIONS
GAAP Reporting
Stock Repurchase @ Exercise Price
Loss on put options is not recognized on balance sheet
Clean-Surplus Reporting
Write off corresponding financial obligations
Common Stock Repurchased at market price
Recognize loss in Income Statement (Retained Earnings)
5. REVERSAL OF DILUTION?
Can repurchase of shares reverse dilution
arising because of stock option being
exercised?
No.
If repurchase is at fair value, there is no change
in per share value of equity. The share holder
doesn’t get extra value to compensate for the
loss of value from stock options.
Only the number of outstanding shares remains unaffected
5. REVERSAL OF DILUTION?
Are repurchases at share prices of 2000
level, advisable?
No.
During tech bubble, employees exercised stock
options at high prices
Firms had to buy back shares at high prices
further increasing the dilution
Double hit for remaining shareholders
6. LOSS TO SHAREHOLDERS
USD Billion
Stock Option Loss 10.672
Tax Benefit @ 37.5% 4.002
Stock Option Loss After-tax 6.67
Tax benefit = $ 4.002 billion
Stock Option Loss = $ 4.002/ 0.375 = $ 10.672 billion
Compensation cost net of tax would be recorded on the income statement
over the period between the option grant date and the date the options become
exercisable
TAX BENEFIT AS CFO
Ideally, Stock based compensation and corresponding
tax benefit should be recognized as cash flow from
operations
GAAP doesn’t recognize Stock based compensation as
an expense
And recognizes tax benefit as financing activity
EITF requires tax benefit to be recognized as CFO
7. TAX BENEFIT– CORRECT TREATMENT
USD Billion
Tax Payable 3.612
Tax benefit 4.002
Tax ( to be paid ) comes to be negative by this calculation
Microsoft should have recognized the compensation expense in Income
statement along with Tax benefit
USD Billion
Income Reported, before Tax 10.624
Loss on exercise of SOP 10.672
Loss before Tax (.048)
Taxes (3.612 – 4.002) (0.390)
Net Income 0.342
8. QUALITY OF REPORTED INCOME
MS pays low tax on a high income
It is recognizing expenses for tax benefit
But the same expense is not carried on its books
Quality of earnings is not reliable.
Other revenues and expenses might not be accurate either
9. ISSUES ARISING IN VALUING SHARES
Share repurchases
Is this at fair value or higher prices?
Put warrant liability
The options are currently out of money
But the exercise date for some was till Dec 2002, and subsequently share price fell drastically.
No liability recorded as put warrants went into money
Nor any loss on these warrants would be recognized when exercised
Valuation of shares should be adjusted accordingly for off-balance sheet liability
9. VALUATION OF SHARES
MS valuation
Preferred Stock Conversion
Book value of preferred stock was converted to book
value of common stock issued and no loss was
recorded
USD
Net proceeds from issue of convertible preferred
stock
$ 1093 million
Number of convertible preferred stock issued 12.5 million
Price per stock ( preferred ) $ 87.4
Conversion Ratio 1.1273 (common
stock )
Price per common stock $ 77
Price / Share on Dec 15, 1999 $ 93
10. KNOWLEDGE LIABILITY
Outstanding
Options (mm)
Wtd. Avg.
exercise
price ($)
Remaining
Life
Black
Scholes
Option Value
Overhan
g ($
mm)
133 4.57 2.1 75.972 10,104
104 10.89 3 70.908 7,374
135 14.99 3.7 68.009 9,181
96 32.08 4.5 56.079 5,384
198 63.19 7.3 45.495 9,008
166 89.91 8.6 40.781 6,770
832 47,821
Note: Additional values required for Black Scholes calculation as on June 30,
2000:
stock price=$80; risk free interest rate=6.2% ; volatility=33%
MICROSOFT IN RECENT YEARS
Current Stock Price: $26.63 Mkt Cap: $224.5 bn
EPS 2000 = 1.35 P/E 1998-2000 = 66
EPS 2011 = 2.52 P/E 1998-2000 = 10.62 P/E Industry =
18.30
QUESTIONS?