2:27

>> So these Black Sholes dudes are Fischer Black and Myron Sholes.

Â And they came up with a closed-form equation for

Â valuing options, building on the work on someone named Robert Merton.

Â Merton and Sholes have actually won the Nobel Prize.

Â Fisher Black would have won it also but he had passed away by then.

Â And you can't win the Nobel Prize, unless you're alive.

Â But anyway, here is the formula from Wikipedia.

Â And if you know your continuous time math then this will make a lot of sense to you.

Â But if you're like most people, this looks like gobbledygook.

Â It's beyond the scope of the course.

Â To go through how this equation works.

Â So for now just trust me that this is the state of the art way to come up

Â with the fair value of an option.

Â And there are people that figure out how to do it.

Â And you'll have to find another course if you want to learn how to

Â apply this Black-Scholes model.

Â And next we're going to take a look at the fair value of 2012 option grants.

Â But before we calculate that, I just want to go through all the information

Â that we're getting on this part of note six on stock-based compensation.

Â The top section pertains to stock options.

Â The bottom to restricted stock units.

Â I'm not going to talk through that.

Â But it's here so you can go through and look at it yourself at your leisure.

Â So going back up to the option part.

Â We have outstanding options at the beginning of the year.

Â Granted options are new options that were granted to employees during 2012.

Â Exercised are those options that have been exercised by employees during the year,

Â and forfeited or expired are either employees have

Â left before the vesting period so they had to give up their options.

Â Or more than ten years have passed and they haven't exercised them.

Â So that gives us the outstanding options at the end of the year.

Â And then below that we have exercisable options.

Â Those are ones that have vested.

Â So you can take the difference between outstanding and

Â exercisable to find out how many have not yet vested.

Â All of the average prices are averaged exercise prices or

Â strike prices for the options.

Â Average life is how long they've been since they, since they were granted.

Â And the intrinsic value is the difference between the current stock price and

Â the exercised price times the number of options.

Â So the value of the option is current market price.

Â Let's say it would be 60.

Â Exercise price is 50.

Â That stock option has an intrinsic value of $10.

Â If you exercised it today you'd get $10 of profit.

Â We take that intrinsic value times all the options that are outstanding or

Â exercisable in these two rows.

Â 5:01

Anyway let's take a look at this fair value of option grants.

Â So the number of options that have been granted are 26,858.

Â Now to find the fair value we don't want to use the $54.09.

Â That's the exercise price.

Â If we go to a different part of the disclosure and look at the number right up

Â here, we the weighted average fair value of options is granted, $13.93.

Â We multiply those together and the total fair value of the option grant is 374,132.

Â >> Why are the fair values of the options so low?

Â Is this Black's fault, or is it Sholes' fault?

Â 5:41

So it's neither Black's fault nor Sholes' fault that the fair values are so low.

Â You want to think of the fair value as the expected profit that you're going to get

Â from this option and keep in mind that if that if the stock price goes down,

Â you get zero profit.

Â So first of all you need the stock price to go up to get any type of profit.

Â And then if the stock price went up $10, you would get a $10 profit on that.

Â So when we're looking at the fair value, we're looking at an expectation based on

Â a lot of parameters, of how much profit you can get.

Â And that's only going to be if the stock price goes up.

Â So it's not a number that you can compare directly to the stock price.

Â Because it's the profit and the movement of stock price,

Â rather than the value of the stock as it is with the share of stock.

Â 6:28

Next we're going to look at the amount of stock-based compensation expense in 2012.

Â And we can't separate how much its stock options versus restricted stock in

Â this disclosure.

Â But if you remember from the statement of shareholders' equity,

Â we saw in the APIC section, the capital in excess of par value.

Â There is a line for stock-based compensation expense.

Â It was 299.

Â Remember the journal entry is debit compensation expense,

Â credit APIC so this is the credit to APIC to the expense was 299.

Â The other place where you can see this stock-based compensation expense is on

Â the statement of cash flows.

Â So here's the cash from operations section.

Â And if you notice here on the third line, stock-based compensation expense, 299.

Â It works just like depreciation, where it's a noncash expense reduces net income.

Â So to get from net income to cash from operations, we have to add it back.

Â So you can generally find stock-based compensation in

Â the statement of stock flows equity.

Â And add it back as a noncash expense in the statement of cash flows.

Â 8:31

Next thing we're going to look at is how much cash did PupCo get from its

Â employees exercising options.

Â So in the disclosure note six, we can see that there were 23,940 options exercised.

Â The average exercise price was 43.47.

Â Which means that the total cash received by

Â PupCo would have been over a billion dollars, so 1,041.

Â And to verify this we can look at statement of cash flows,

Â the cash from the financing section.

Â And we have a line that says proceeds from exercises of stock options,

Â which is 1,038.

Â Supposed to be pretty much the same number.

Â I guess there must have been some rounding error here or

Â there, but what's $3 million among friends.

Â So basically the same number we see here on the cash flow statement as we

Â saw in the footnote.

Â 9:21

>> Before you go on and tell us about more rounding errors,

Â can you explain the excess tax benefits from share-based compensation line?

Â >> So the excess tax benefits line that you see here in the statement of cash

Â flows are the tax savings that the company gets when employees exercise options.

Â So remember in a prior video, when an employee exercises an option,

Â the difference between the current stock price and

Â the exercise price is taxable income for the employee.

Â Becomes a tax deduction for the company.

Â The company can use that tax deduction to save on taxes, and

Â we show those tax savings here in cash from financing.

Â Now it's a little bit more complicated than that.

Â Some of these tax benefits actually do work their way through operating.

Â But the best way and the easiest way for

Â our purposes to think about this are these excess tax benefits are the tax

Â savings the company gets anytime an employee exercises a stock option.

Â 'Kay next, we're going to look at where that stock came from to sell to

Â employees for the stock options.

Â So we go back to the statement of stock holders equity,

Â the repurchase stock section, treasury stock section.

Â And there's a line item that says stock option exercises, 1,487.

Â So the, we, PupCo used treasury shares to reissue to employees for stock options.

Â The amount was 1.5 billion or 1,487.

Â And the average price of that treasury stock was 61.96.

Â And we can get that by taking 1,487 divided by

Â the 24 million of shares that were reissued for stock option exercises.

Â So it looks like the exercise price on the stock options was 43.47.

Â And we satisfied it by reissuing treasury share that we originally bought at 61.96.

Â >> So, is this the real economic cost of stock options?

Â A company buys back stock at $62 and sells it to employees for only $43?

Â They are losing almost $20 per option!

Â >> Yeah, but we talked about stock compensation earlier.

Â We had mentioned that it seems to be a form of compensation where

Â there's no cash outflow.

Â And certainly if PupCo had just issued new shares,

Â there would have been no cash outflow at all.

Â But, of course, that dilutes the ownership of current shareholders.

Â Current shareholders don't like that.

Â And so companies often tend to use treasury stock to

Â satisfy these employee stock option purchases.

Â If you're going to purchase the stock as you sell to the employees,

Â you will always take a loss as we see here.

Â Because you're basically buying at the current price and

Â selling it to the employees at the lower exercise price.

Â So companies often try to manage this by buying the treasury stock earlier.

Â Or they'll buy stock options in their own stock so

Â that they could buy it at a lower price.

Â But, but yeah, if you just compare the, the price of the treasury stock

Â to the price that you're getting on the stock options, that is a quick and

Â dirty measure of the true cash cost of this option compensation for the company.

Â 12:25

The final thing we're going to look at is basic versus diluted earnings per

Â share for PupCo.

Â And try to figure out why diluted EPS is less than basic EPS.

Â Before we do that, we look at the disclosure.

Â We've got net income.

Â Then we subtract out the preferred dividends and

Â redemptions to get net income for common shareholders.

Â So that's the 6,314, which is the numerator in basic EPS.

Â Then we have the weighted average shares outstanding which are 1,590.

Â So if you take 6,314 divide it by 1,590,

Â you get the basic earnings per share of 3.97 in 2012.

Â Now below that we can see that the dilutive securities.

Â So we see that there's convertible preferred stock which had an effect on

Â both the numerator and denominator.

Â So if the convertible preferred stock converted to common stock,

Â then that preferred dividend would go away.

Â So we would add back the six that we have subtracted above.

Â And then in denominator, there'd be an extra 1 million shares outstanding, so

Â we add that to the weighted average commons shares.

Â Then there's stock options and restricted stock units.

Â That has no effect on the numerator.

Â So remember from the prior videos stock options, when we talk about diluted EPS,

Â it doesn't have any effect on the net income or

Â the preferred dividends whether it has converted or not.

Â All the effect is on the denominator, and

Â it would be an extra 23 million shares issued.

Â And that's only stock options and

Â restricted stock units that are in the money.

Â If you notice down below there, it says in the last sentence, options to purchase 24

Â million shares in 2012 were not included in the calculation of diluted EPS.

Â Because the options were out of the money.

Â So the out of the money options don't count because the assumption is

Â that they wouldn't convert since they're out of the money.

Â So then we divide 6,320 by 1,614 and we get a diluted

Â EPS of 3.91 so we have basic of 3.97 and diluted of 3.91.

Â >> Six lousy cents!

Â It makes no sense to have to do a complex diluted EPS calculation to

Â find a lousy six cent difference.

Â 14:43

>> Come on Dave.

Â Give me break.

Â How many times you been walking down the street, seeing a penny laying on

Â the sidewalk, and picked it up, and happily put that one cent in your pocket?

Â So $0.06 can matter.

Â Especially if you own say 1% of PupCo's outstanding shares.

Â That's 10 million shares of stock.

Â 10 million times $0.06 is $600,000.

Â That would be a lot of net income that's going into the pockets of these

Â convertible debt or stock option holders instead of your own pocket.

Â So this stuff can add up pretty quickly and

Â so $0.06 in this case can really matter.

Â