Hello I'm Professor Brian Bushee. Welcome back. In this video we're going to continue our look at the PupCo financial statements and focus on their disclosures related to stock-based compensation. Hope you enjoy the video. Okay, our disclosure examples again looking at PupCo, which manufactures health drinks for dogs and cats, things like the liver and T-Bone latte or the mouse-infused macchiato. And now we're going to try to answer some questions about PupCo from their stock-based compensation and their EPS disclosures. So first what are the terms of PupCo's stock options like the exercise price, vesting period, and the length of the options. What was the total fair value of stock options granted in 2012? How much stock-based compensation expense was recorded in 2012? How much cash did PupCo receive from options exercised in 2012? And what was the source of the stock that was sold to employees exercising options? And then what type of convertibles caused diluted EPS to be less than basic EPS in 2012? So note six of PupCo's disclosures gives us the stock-based compensation footnote. You notice at the top they say our stock-based compensation program's designed to attract and retain employees. While also aligning employees' interests with the interest of our shareholders. They give both stock options and restricted stock. We're going to focus on the stock options for this video. So looking at some of the terms of the stock options, for the exercise price if we look at the second paragraph. Second sentence it says all stock option grants have an exercise price equal to the fair market value of common stock on the date of grant. So these are all issued at the money. The length it says generally ten years. So you, after it vests, you have up to ten years to exercise the option. After that, it expires. The vesting period it says, that the fair value of option grants is amortized to expense over the vesting period which is generally three years. And the valuation for accounting purposes at the first sentence of this second paragraph, they say that we use the Black-Scholes valuation model. >> Who are the Black and Sholes dudes? And what is their model? >> So these Black Sholes dudes are Fischer Black and Myron Sholes. And they came up with a closed-form equation for valuing options, building on the work on someone named Robert Merton. Merton and Sholes have actually won the Nobel Prize. Fisher Black would have won it also but he had passed away by then. And you can't win the Nobel Prize, unless you're alive. But anyway, here is the formula from Wikipedia. And if you know your continuous time math then this will make a lot of sense to you. But if you're like most people, this looks like gobbledygook. It's beyond the scope of the course. To go through how this equation works. So for now just trust me that this is the state of the art way to come up with the fair value of an option. And there are people that figure out how to do it. And you'll have to find another course if you want to learn how to apply this Black-Scholes model. And next we're going to take a look at the fair value of 2012 option grants. But before we calculate that, I just want to go through all the information that we're getting on this part of note six on stock-based compensation. The top section pertains to stock options. The bottom to restricted stock units. I'm not going to talk through that. But it's here so you can go through and look at it yourself at your leisure. So going back up to the option part. We have outstanding options at the beginning of the year. Granted options are new options that were granted to employees during 2012. Exercised are those options that have been exercised by employees during the year, and forfeited or expired are either employees have left before the vesting period so they had to give up their options. Or more than ten years have passed and they haven't exercised them. So that gives us the outstanding options at the end of the year. And then below that we have exercisable options. Those are ones that have vested. So you can take the difference between outstanding and exercisable to find out how many have not yet vested. All of the average prices are averaged exercise prices or strike prices for the options. Average life is how long they've been since they, since they were granted. And the intrinsic value is the difference between the current stock price and the exercised price times the number of options. So the value of the option is current market price. Let's say it would be 60. Exercise price is 50. That stock option has an intrinsic value of $10. If you exercised it today you'd get $10 of profit. We take that intrinsic value times all the options that are outstanding or exercisable in these two rows. Anyway let's take a look at this fair value of option grants. So the number of options that have been granted are 26,858. Now to find the fair value we don't want to use the $54.09. That's the exercise price. If we go to a different part of the disclosure and look at the number right up here, we the weighted average fair value of options is granted, $13.93. We multiply those together and the total fair value of the option grant is 374,132. >> Why are the fair values of the options so low? Is this Black's fault, or is it Sholes' fault? So it's neither Black's fault nor Sholes' fault that the fair values are so low. You want to think of the fair value as the expected profit that you're going to get from this option and keep in mind that if that if the stock price goes down, you get zero profit. So first of all you need the stock price to go up to get any type of profit. And then if the stock price went up $10, you would get a $10 profit on that. So when we're looking at the fair value, we're looking at an expectation based on a lot of parameters, of how much profit you can get. And that's only going to be if the stock price goes up. So it's not a number that you can compare directly to the stock price. Because it's the profit and the movement of stock price, rather than the value of the stock as it is with the share of stock. Next we're going to look at the amount of stock-based compensation expense in 2012. And we can't separate how much its stock options versus restricted stock in this disclosure. But if you remember from the statement of shareholders' equity, we saw in the APIC section, the capital in excess of par value. There is a line for stock-based compensation expense. It was 299. Remember the journal entry is debit compensation expense, credit APIC so this is the credit to APIC to the expense was 299. The other place where you can see this stock-based compensation expense is on the statement of cash flows. So here's the cash from operations section. And if you notice here on the third line, stock-based compensation expense, 299. It works just like depreciation, where it's a noncash expense reduces net income. So to get from net income to cash from operations, we have to add it back. So you can generally find stock-based compensation in the statement of stock flows equity. And add it back as a noncash expense in the statement of cash flows. >> Yet another noncash expense to add back on the SCF. How do you expect us to keep track of all of these? Put up the SCF again. Look at how long this section is. What the lamb? >> I'm so sorry that there are so many of these add-backs in the SCF that you have to keep track of but we put a lot of noncash expenses into net income. And if we're going to go from net income, the cash flow under the indirect method, we gotta add them back or subtract them out. The good news I guess is that if you're just going to be a user of financial statements rather than a preparer, you don't have to memorize them. You can just look at the statement of cash flows. And you'll see all these noncash expenses or revenues added back or subtracted out on the face of the statement. I just need you to be aware, aware of why they're there. And recognize that these are noncash items which is why they're adjusted, not cash items. Next thing we're going to look at is how much cash did PupCo get from its employees exercising options. So in the disclosure note six, we can see that there were 23,940 options exercised. The average exercise price was 43.47. Which means that the total cash received by PupCo would have been over a billion dollars, so 1,041. And to verify this we can look at statement of cash flows, the cash from the financing section. And we have a line that says proceeds from exercises of stock options, which is 1,038. Supposed to be pretty much the same number. I guess there must have been some rounding error here or there, but what's $3 million among friends. So basically the same number we see here on the cash flow statement as we saw in the footnote. >> Before you go on and tell us about more rounding errors, can you explain the excess tax benefits from share-based compensation line? >> So the excess tax benefits line that you see here in the statement of cash flows are the tax savings that the company gets when employees exercise options. So remember in a prior video, when an employee exercises an option, the difference between the current stock price and the exercise price is taxable income for the employee. Becomes a tax deduction for the company. The company can use that tax deduction to save on taxes, and we show those tax savings here in cash from financing. Now it's a little bit more complicated than that. Some of these tax benefits actually do work their way through operating. But the best way and the easiest way for our purposes to think about this are these excess tax benefits are the tax savings the company gets anytime an employee exercises a stock option. 'Kay next, we're going to look at where that stock came from to sell to employees for the stock options. So we go back to the statement of stock holders equity, the repurchase stock section, treasury stock section. And there's a line item that says stock option exercises, 1,487. So the, we, PupCo used treasury shares to reissue to employees for stock options. The amount was 1.5 billion or 1,487. And the average price of that treasury stock was 61.96. And we can get that by taking 1,487 divided by the 24 million of shares that were reissued for stock option exercises. So it looks like the exercise price on the stock options was 43.47. And we satisfied it by reissuing treasury share that we originally bought at 61.96. >> So, is this the real economic cost of stock options? A company buys back stock at $62 and sells it to employees for only $43? They are losing almost $20 per option! >> Yeah, but we talked about stock compensation earlier. We had mentioned that it seems to be a form of compensation where there's no cash outflow. And certainly if PupCo had just issued new shares, there would have been no cash outflow at all. But, of course, that dilutes the ownership of current shareholders. Current shareholders don't like that. And so companies often tend to use treasury stock to satisfy these employee stock option purchases. If you're going to purchase the stock as you sell to the employees, you will always take a loss as we see here. Because you're basically buying at the current price and selling it to the employees at the lower exercise price. So companies often try to manage this by buying the treasury stock earlier. Or they'll buy stock options in their own stock so that they could buy it at a lower price. But, but yeah, if you just compare the, the price of the treasury stock to the price that you're getting on the stock options, that is a quick and dirty measure of the true cash cost of this option compensation for the company. The final thing we're going to look at is basic versus diluted earnings per share for PupCo. And try to figure out why diluted EPS is less than basic EPS. Before we do that, we look at the disclosure. We've got net income. Then we subtract out the preferred dividends and redemptions to get net income for common shareholders. So that's the 6,314, which is the numerator in basic EPS. Then we have the weighted average shares outstanding which are 1,590. So if you take 6,314 divide it by 1,590, you get the basic earnings per share of 3.97 in 2012. Now below that we can see that the dilutive securities. So we see that there's convertible preferred stock which had an effect on both the numerator and denominator. So if the convertible preferred stock converted to common stock, then that preferred dividend would go away. So we would add back the six that we have subtracted above. And then in denominator, there'd be an extra 1 million shares outstanding, so we add that to the weighted average commons shares. Then there's stock options and restricted stock units. That has no effect on the numerator. So remember from the prior videos stock options, when we talk about diluted EPS, it doesn't have any effect on the net income or the preferred dividends whether it has converted or not. All the effect is on the denominator, and it would be an extra 23 million shares issued. And that's only stock options and restricted stock units that are in the money. If you notice down below there, it says in the last sentence, options to purchase 24 million shares in 2012 were not included in the calculation of diluted EPS. Because the options were out of the money. So the out of the money options don't count because the assumption is that they wouldn't convert since they're out of the money. So then we divide 6,320 by 1,614 and we get a diluted EPS of 3.91 so we have basic of 3.97 and diluted of 3.91. >> Six lousy cents! It makes no sense to have to do a complex diluted EPS calculation to find a lousy six cent difference. >> Come on Dave. Give me break. How many times you been walking down the street, seeing a penny laying on the sidewalk, and picked it up, and happily put that one cent in your pocket? So $0.06 can matter. Especially if you own say 1% of PupCo's outstanding shares. That's 10 million shares of stock. 10 million times $0.06 is $600,000. That would be a lot of net income that's going into the pockets of these convertible debt or stock option holders instead of your own pocket. So this stuff can add up pretty quickly and so $0.06 in this case can really matter. And that wraps up our look at the disclosure example. Join me next time where we go through. Through the 3M Company's financial statements to look at these disclosures. And we'll try to find out if 3M Company makes post-it notes for dogs. Which would make it a nice compliment to the PupCo company. I'll see you then. >> Dave, are we going to back next week? I want to say, you know what, but it doesn't make sense if we won't be back? Says here we'll be back. >> See you next video!
