2:27

>> 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.

5:01

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?

5:41

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.

6:28

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.

8:31

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.

9:21

>> 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.

12:25

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.

14:43

>> 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.