Financial Modeling Self Study Program

How do we use the Treasury Stock Method to calculate diluted shares?

To use the Treasury Stock Method, we first need a tally of the company’s issued stock options and weighted average exercise prices.  We get this information from the company’s most recent 10K.  If our calculation will be used for a control based valuation methodology (i.e. precedent transactions) or M&A analysis, we will use all of the options outstanding.  If our calculation is for a minority interest based valuation methodology (i.e. comparable companies) we will use only options exercisable.  Note that options exercisable are options that have vested while options outstanding takes into account both options that have vested and that have not yet vested.

Once we have this option information, we subtract the exercise price of the options from the current share price (or per share purchase price for an M&A analysis), divide by the share price (or purchase price) and multiply by the number of options outstanding.  We repeat this calculation for each subset of options reported in the 10K (usually companies will report several line items of options categorized by exercise price).  Aggregating the calculations gives us the amount of diluted shares.  If the exercise price of an option is greater than the share price (or purchase price) then the options are out-of-the-money and have no dilutive effect.

The concept of the treasury stock method is that when employees exercise options, the company has to issue the appropriate number of new shares but also receives the exercise price of the options in cash.  Implicitly, the company can “use” this cash to offset the cost of issuing new shares.  This is why the diluted effect of exercising one option is not one full share of dilution, but a fraction of a share equal to what the company does NOT receive in cash divided by the share price.

How do you calculate fully diluted shares?

To calculate fully diluted shares, we need to add the basic number of shares (found on the cover of a company’s most recent 10Q or 10K) and the dilutive effect of employee stock options.  To calculate the dilutive effect of options we typically use the Treasury Stock Method.  The options information can be found in the company’s latest 10K.  Note that if the company has other potentially dilutive securities (e.g. convertible preferred stock or convertible debt) we may need to account for those as well in our fully diluted share count.

What is the difference between basic shares and fully diluted shares?

Basic shares represent the number of common shares that are outstanding today (or as of the reporting date).  Fully diluted shares equals basic shares plus the potentially dilutive effect from any outstanding stock options, warrants, convertible preferred stock or convertible debt.  In calculating a company’s market value of equity (MVE) we always want to use diluted shares.  Implicitly the market also uses diluted shares to value a company’s stock.

How do you calculate the market value of equity?

A company’s market value of equity (MVE) equals its share price multiplied by the number of fully diluted shares outstanding.

Why do you subtract cash in the enterprise value formula?

Cash gets subtracted when calculating Enterprise Value because (1) cash is considered a non-operating asset AND (2) cash is already implicitly accounted for within equity value.  Note that when we subtract cash, to be precise, we should say excess cash.  However, we will typically make the assumption that a company’s cash balance (including cash equivalents such as marketable securities or short-term investments) equals excess cash.

What is Minority Interest and why do we add it in the Enterprise Value formula?

When a company owns more than 50% of another company, U.S. accounting rules state that the parent company has to consolidate its books.  In other words, the parent company reflects 100% of the assets and liabilities and 100% of financial performance (revenue, costs, profits, etc.) of the majority-owned subsidiary (the “sub”) on its own financial statements.  But since the parent company does not 100% of the sub, the parent company will have a line item called minority interest on its income statement reflecting the portion of the sub’s net income that the parent is not entitled to (the percentage that it does not own).  The parent company’s balance sheet will also contain a line item called minority interest which reflects the percentage of the sub’s book value of equity that the parent does NOT own.  It is the balance sheet minority interest figure that we add in the Enterprise Value formula.

Now, keep in mind that the main use for Enterprise Value is to create valuation ratios/metrics (e.g. EV/Sales, EV/EBITDA, etc.)  When we take, say, sales or EBITDA from the parent company’s financial statements, these figures due to the accounting consolidation, will contain 100% of the sub’s sales or EBITDA, even though the parent does not own 100%.  In order to counteract this, we must add to Enterprise Value, the value of the sub that the parent company does not own (the minority interest).  By doing this, both the numerator and denominator of our valuation metric account for 100% of the sub, and we have a consistent (apples to apples) metric.

One might ask, instead of adding minority interest to Enterprise Value, why don’t we just subtract the portion of sales or EBITDA that the parent does NOT own.  In theory, this would indeed work and may in fact be more accurate.  However, typically we do not have enough information about the sub to do such an adjustment (minority owned subs are rarely, if ever, public companies).  Moreover, even if we had the financial information of the sub, this method is clearly more time consuming.

What is the difference between enterprise value and equity value?

Enterprise Value represents the value of the operations of a company attributable to all providers of capital.  Equity Value is one of the components of Enterprise Value and represents only the proportion of value attributable to shareholders.