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?