The last step within a DCF valuation, is to divide the estimated fair equity value over number of shares outstanding to get to your estimate of fair value per share. This article discusses how to calculate the number of shares outstanding correctly and related issues, such as …
… Expected Dilution, Shares with Different Rights, and Option and Share Grants to Employees. First, I introduce some basic terms about Different Share Counts. If you only want to get a quick overview about how to handle the discussed issues you can skip the article and go to the Summary directly. List of important reads:
- Most essential read from Prof. Damodaran about Share Count Confusion: Dilution, Employee Options and Multiple Share Classes!
- About different Share Counts: https://www.wallstreetmojo.com/outstanding-shares-stocks/
Authorized Shares is the amount of shares a company is legally allowed to issue by the board/shareholders, thus actually Issued Shares by the company is always lower. (Here is a good example to be found)
Outstanding shares are the shares owned by stockholders, company officials, and investors in the public domain, including retail investors, institutional investors, and insiders. However, stocks outstanding does not include treasury stock.https://www.wallstreetmojo.com/outstanding-shares-stocks/
A company also often keeps a portion of its outstanding shares of stock in its own treasury, from both the initial stock issue as well as stock repurchases. These are called “treasury shares,” and are not included in outstanding stocks balance. Increasing treasury shares will always result in decreases or (and vice-versa).https://www.wallstreetmojo.com/outstanding-shares-stocks/
Float means any shares available to the public and excludes any restricted shares, or shares held by company officers or insiders.
Basic vs. Diluted Share Counts
Basic shares mean the number of outstanding stocks currently outstanding, while the fully diluted number takes into account things such as warrants, capital notes, and convertible stock. In other words, the fully diluted number of Stocks outstanding tells you how many outstanding stocks there could potentially be.https://www.wallstreetmojo.com/outstanding-shares-stocks/
If (especially young technology) Companies do not generate enough Cash (from Operations) to cover their capital needs, they can issue more shares to the public to fund there investments/operations. As the company issues more shares, the share count (Number of Outstanding Shares) will increase in the future and lead to dilution, meaning current shareholders will own fewer shares of the company on a relative basis if they do not buy more. This translates into lower claims on future profits, again relativley speaking. According to Damodaran the right response is to do nothing:
If you are doing a discounted cash flow valuation, the right response to the expected dilution is to do nothing. That may sound too good to be true, but it is true, and here is why. The aggregate value of equity that you compute today includes the present value of expected cash flows, including the negative cash flows in the up front years. The latter will reduce the present value (value of operating assets), and that reduction captures the dilution effect. You can divide the value of equity by the number of share outstanding today, and you will have already incorporated dilution.Damodaran about Share Count Confusion: Dilution, Employee Options and Multiple Share Classes!
Shares with Different Rights
If shares to be valued have less rights (ie. fewer voting rights, less dividend, …) attached than other issued share classes by the same company, there is a rather easy way to tackle this issue. Just assume that each share with more rights attached is as valuable as (1+x) shares that you try to value, then adjust the Number of Shares Outstanding accordingly.
Option and Share Grants to Employees
Many Companies ‘pay’ their employees partly in Stock options or Shares. This topic is easier to discuss if we split it in two sub-chapters about (a) Past and (b) Future Option and Share Grants.
Past Option and Share Grants
If you own shares in a company, the shares and options granted by the firm in prior years to employees represent claims on the equity, that reduces your value per share.Damodaran about Share Count Confusion: Dilution, Employee Options and Multiple Share Classes!
The shares issued in the past are simple to deal with, since adding them to the share count will reduce the value per share today. The fact that employees have to vest (which requires staying with the firm for a specified time period) and that the shares have restrictions on trading can make them less valuable than unrestricted shares, but that is a relatively small problem.
The options that have been granted in the past are a bigger challenge, since they represent potential dilution, but only if the share price rises above the exercise price. Option pricing models are designed to capture the probabilities of this happening and can be used to value options, no matter how in or out of the money the options are. In an intrinsic valuation, you should value these options first (using an option pricing model) and net the value [of granted options] out of the estimated value of equity, before dividing by the existing share count.
Future Option and Share Grants
To the extent that a company is expected to continue to compensate its employees with options or restricted shares in future years, the most logical way to deal with these grants is to treat them as expenses in future years, and reduce expected income and cash flows. Rather than grapple with expected future share prices, you should estimate the expenses (associated with SBC) as a percent of revenues, and use that forecast as the basis for expenses in the future. Until accounting came to its senses in 2004 and required companies to expense share based compensation at the time of grant, this was an onerous exercise for analysts, since it required estimating the value of option and share grants in past years to get historical numbers on the value of SBC grants. With the prevalent accounting rules in both GAAP and IFRS, the earnings that you see for companies should already be adjusted for SBC expenses and reported income should therefore give you a fair basis for forecasting.Damodaran about Share Count Confusion: Dilution, Employee Options and Multiple Share Classes!
There is a correct way to deal with each issue, ometimes there exist other alternatives but the following should be the standard approach for handling them:
- If you expect dilution, just do nothing about it; just incorporate the negative exp. Cashflow figures (FCFF) when performing the DCF Valuation.
- Shares with different rights can be accounted for by adjusting the Number of Shares Outstanding (upwards if you value shares with fewer rights).
- Tread Past Option and Share Grants to employees as another claim on equity. Value the Options first and net the value out of the estimated value of equity, before dividing by the existing eff. share count. Shares issued in the past are to be added to the share count and thus will reduce the FVpS.
- Consider Future Option and Share Grants to employees as another line item as part of real Operating Expenses in each future year, reducing the Operating Margin and exp. Cashflow each year. Current accounting periods can serve as a starting point for modeling SCB-expenses.
I hope you enjoyed this post and maybe I was even capable answering some open questions for you. If there are any related questions left, I look forward to your comments below.