Equity value typically refers to the market value of a company’s common equity. It is the residual claim on the assets of a firm after all liabilities and any preferred shares are settled.
If a company is public, the equity value can easily be calculated by multiplying the number of diluted shares outstanding by the latest price per common share of the company. If the company is not public, other valuation methods such as comparables or discounted cash flows can be used.
When calculating a company’s market capitalization, we use the current stock price. So, ideally, we want to use an equally timely number of shares outstanding given the share price reflects all available information. However, companies only disclose shares outstanding quarterly, so we often have to rely on the most recent disclosure.
In determining the number of shares used in the equity value calculation, we start with the basic number of shares outstanding. Basic shares represent number of shares that are issued and outstanding as of the reporting or current date. It does not include shares that may be issued at a future date as a result of dilutive instruments such as options. The basic number can be found in the company’s most recent the balance sheet, footnotes and/or the MD&A.
Sometimes companies will disclose a more current number of shares (i.e. later than the date of the balance sheet). Companies that file with the SEC (annual 10Ks and quarter 10Qs) need to disclose the number of shares outstanding as of the date of their filing of the document, so they will always show a more current number. In 10Ks and 10Qs, the number of shares outstanding as of the filing date will be shown on the cover of the document, as shown below:
In Microsoft’s 10Q above, the financial period ended on September 20, 2018 but the number of shares disclosed is as of October 19, 2018, which was the filing date for the 10Q.
Be careful when using number of shares from a different date than the balance sheet date. If the company issued or repurchased a significant number of shares between the balance sheet date and the filing date, then the values will not be presented on a consistent basis. When calculating enterprise value, the balance sheet may need to be adjusted to reflect the change in share count. For instance, if the company completed a significant share repurchase after quarter-end but before the filing date, the cash balance on the balance sheet will need to be adjusted downward to account for the cash assumed to have been used in the share buyback.
It is also very important to check for stock splits (or stock consolidations) that may have occurred after the latest filing, and to make appropriate adjustments to the share count.
Fully diluted shares outstanding (FSDO) includes basic shares outstanding, plus shares that would be outstanding if all the dilutive equity instruments were exercised / converted.
Options and warrants are equity instruments that give the holder the right to purchase shares in the company at a specified price (exercise price) for a given period of time. If the exercise price is below the current share price, then the option or warrant is said to be in-the-money. All in-the-money options or warrants are dilutive.
Other dilutive instruments could include debt or preferred shares convertible into common stock, as well as Restricted Stock Units, Performance Stock Units and Director Stock Units issued to employees and directors.
The number of FDSO as of a particular date (usually the most current date available) is used to calculate a company’s market capitalization (i.e. share price x number of shares) and in turn its enterprise value.
Equity investors know that there are potentially dilutive instruments outstanding, and they factor this dilution into the common stock price when calculating the aggregate value of the equity of a company. Therefore, to arrive at the true market value of a company’s equity, we need to include the corresponding number of dilutive shares in the calculation.
To arrive at FDSO:
Stock options are awarded by many companies to executives and other key employees as an incentive and compensation tool. Options give the holder the right to purchase the company’s stock at a specified price for a period of time. However, on many occasions the options are not immediately exercisable by the holder – instead they have a vesting period to serve as a retention mechanism for the employee.
Note that companies typically disclose two options figures:
When adjusting equity value for dilution, some professionals use total options and others use only exercisable options, so be sure to check with your team. In either case, only those options with a strike price below the current market price of the stock (i.e. in-the-money) should be used. Only in-the-money options are expected to be dilutive to existing shareholders since the option holder will have an economic incentive to exercise the options at a discount to the current market price and add to the shares outstanding.
Companies typically disclose the most amount of detail regarding their outstanding options in their annual filings. Check the footnote called Share-Based Compensation for an options table like the one below:
Note that the options are broken out in tranches based on their exercise prices, and for each tranche the weighted-average exercise price is shown. Assuming we are using the total number of options outstanding, if this company’s stock price was currently $39.00, the first three tranches in the table would be in-the-money based on their weighted average exercise price, whereas the fourth tranche would not be in-the-money. As a result, we would add roughly 6.7 mm shares to the basic shares outstanding.
However, if we assume that the in-the-money options are exercised, the company would then have the cash proceeds from those options. Using the numbers from table above and a $39.00 stock price, the cash proceeds would be:
(215,000 * $27.17) + (1,497,000 * $33.11) + (5,009,000 * $37.89) = $245.2 mm
We can either assume that the cash stays on the balance sheet, or we can assume that the company uses the cash to repurchase stock at the current market price. This latter approach is called the Treasury Stock Method.
Sometimes companies will provide additional option disclosure in their quarterly filings, so it may be possible to update the figures found in the annual report or 10K.
Warrants are very similar to options, except that they are usually issued to investors as opposed to employees. If a company has issued warrants, they should be treated the same way that the options are treated.
The Treasury Stock Method (TSM) is a method of calculating the total number of Fully Diluted Shares Outstanding for a company. In this case, when in-the-money options are assumed to be exercised, the related cash proceeds are assumed to be used to repurchase common stock at the current market price.
Using option information in the table below, assuming a current share price of $39.00, 6.7 mm options would be assumed to be exercised, generating $245 mm of cash proceeds.
(215,000 * $27.17) + (1,497,000 * $33.11) + (5,009,000 * $37.89) = $245.2 mm
Using the TSM, 6.3 mm shares are assumed to be repurchased at the market price of $39.00, as shown below:
The net increase in the number of shares is 433,866 which is the true dilution from the options. Dilution to existing shareholders occurs because the company is effectively selling shares at a discount to the market price.
Public companies often award stock units as incentive / retention tools to executives and board members. Stock units are essentially deferred stock compensation that give the holder a certain number of shares (or sometimes the equivalent value in cash based on the market value of the stock) when the units vest.
Restricted Stock Units (RSUs) and Deferred Stock Units (DSUs) give the holder shares (typically on a 1 for 1 basis) when they vest on a particular date. Performance Share Units (PSUs) are similar, but usually vest only if certain performance targets are met.
There are no cash proceeds when the units vest – their value mimics the common share price. Thus, these instruments are purely dilutive and need to be added to the share count to arrive at Fully Diluted Shares Outstanding in calculating equity value.
Convertible debt is attractive to some investors because it allows them to minimize their downside risk but also have the ability to participate in the upside of a company. These are particularly useful for newer companies or start-ups – if the company struggles, investors should still be able to salvage some principal from the debt, but if the company becomes successful, investors have the ability to convert their debt into equity of the company.
Convertible debt is typically convertible into a fixed number of common shares, which yields an implied conversion price. For example, a $1,000 face value bond might be convertible into 30 common shares – thus the implied conversion price is $1,000 / 30 = $33.33. If the underlying share price exceeds the conversion price, then the instrument is in-the-money since the stock is worth more than the debt.
If the debt is in-the-money, then the instrument is assumed to be converted and the resulting number of as-converted shares is added to the share count. If not, the amount is left as debt in the calculation of enterprise value.
Importantly, this is different than the accounting treatment of convertible debt. While the debt is outstanding and unconverted, accounting rules will present part of the debt’s value as a liability, and part of it as equity. It is important to read the footnotes to the financials to understand the terms of any convertible debt.
Convertible preferred shares are attractive to investors as they allow them to minimize their downside risk but also have the ability to participate in the upside of a company. These are hybrid securities because they give the investor a priority claim on the company’s assets relative to common equity, but typically have no voting rights.
Convertible preferred shares work just like convertible debt in calculating Fully Diluted Shares Outstanding for equity value. The preferred shares will have an implied conversion price – if they are in-the-money, financial analysts will generally treat them as converted and include them in the share count for common shares outstanding.