An Accounting Homework Assignment for Those of You Who Want to Learn to Analyze Businesses

I haven't had much time to really dig in, but from a cursory glance it appears to be a result of issuing/exchanging a specific number of non voting share for common shares. From their 10K:

"In certain circumstances, we issue shares of CS in exchange for shares of CSNV, or issue shares of CSNV in exchange for shares of CS...Typically, these exchanges are made in connection with the administration of our employee benefit plans, executive compensation programs and dividend reinvestment/direct purchase plans. The number of shares issued in an exchange is generally equal to the number of shares received in the exchange, although the number may differ slightly to the extent necessary to comply with the requirements of the Employee Retirement Income Security Act of 1974. During fiscal 2014, we issued 801,705 shares of CSNV in exchange for shares of CS and issued 21,490 shares of CS in exchange for shares of CSNV."

So I'd wager this doesn't have much of an impact on intrinsic value since it has to do with compliance with the "Employee Retirement Income Security Act of 1974" rather than anything shady on McCormick's part. I'd be curious to know what about that act does in fact make the exchange different from 1:1, but that's something I'll need to investigate when I get some time later today.

The lesson is to always read 10-K's, footnotes, letters from management, etc instead of investing only on quantitative factors like looking at income growth or P/E ratios. These are good directional indicators, but we really need to understand the drivers of business and what constitutes these numbers. Is net income primarily derived from legitimate operations or are there a lot of one time sales of assets or interest income? We can't know only by looking at an income statement, so the smart investor has to do their homework, and read!

Yes, there are two different share classes; however, they have the same economic interest. The difference between the two is voting interest. There is something else going on...

Right but it seems they may issue them at different rates. From this part:

"The number of shares issued in an exchange is generally equal to the number of shares received in the exchange, although the number may differ slightly to the extent necessary to comply with the requirements of the Employee Retirement Income Security Act of 1974."

I could definitely be missing something, but that seems like it might explain it to me. While the economic interest is the same, the # of shares may not be.

Hint: There is a fourth statement in addition to Income, Balance Sheet, and Cash Flow...The statement of Shareholders Equity.

RSUs as part of employee compensation, but I believe that's what the exchange of voting vs non-voting was sort of referring to, no?

Ladies and Gents- As an FYI and to save you some energy, industry standard is to refer to the statute as ERISA. Carry on.

2) Footnote 11 - Stock Based Compensation

Three rollforwards: RSU, Stock Options, LTPP

RSU grants (2012, 2013, 2014): 113k, 89k, 180k
Stock Option grants (2012, 2013, 2014): 900k, 900k, 1100k
LTPP (2012, 2013, 2014): 120k, 94k, 105k

Total: 3.6m new shares (diluted, far less if basic)

3) The cost (or perhaps benefit in this case) is that the company doesn't pay cash to its employees in lieu of options and stock - however, FAS 123R requires recognition of expense, so net-net it's a wash. Perhaps the Company gets a gain in cash flow from operations, but it also loses on cash flow from financing activities (if it had issued in the open market for example, net of frictional costs to accounting firms and underwriters)

4) It just means you can ignore the noise on buybacks - if anything, it raises the question of: since it seems that the stock might be overvalued, do you think it's wise of management to do buybacks currently? Although, I suppose they also get a boost from the publicity

5) I think the lesson is that stock analysis is a lot of work and most people should invest in index funds : )

You're on the right track, but I think you've committed a mental error. You found a total that amounted to close to the 3.3 million; however, that is an issuance of shares. Joshua's question is: Why did the shares only go DOWN by 3.3 million.

He's expecting shares to go down by 7.5m total - 5.57%, but it only went down by 3.3m, so that leaves 4.2m of issuances/grants, etc. I could only get to 3.6m of the 4.2m, would need to look deeper into the equity roll to figure that out

"...would need to look deeper into the equity roll to figure that out"
You have given yourself another assignment. Go.

He's expecting shares to go down by 7.5m total - 5.57%

In actuality, I would have expected them to decline by much more. This was a worst-case scenario assuming the absolute, most godawful, highest price paid for the stock, which wasn't mathematically possible over the timeframe.

Again, late to the party and just as an FYI (I'm reading this like a novel, so it may have been addressed below), but expensing of options/RS/equity based grants is not always straight line over the vesting period. IIRC, it depends on whether the vesting is time based or performance based.

"Its operating earnings after interest expense but before income taxes relative to average tangible capital employed comes in at ~25%, putting it in the “excellent business” category."

Joshua, just curious about your ROC formula. Why don't you include interest expense? Isn't that part of the return to the total capital pool of equity + debt? That is, the tangible capital of the enterprise is funded by equity and debt, so the return on that capital should include EBIT, no? Some use a pre-tax ROIC, others, after tax, but both, I believe, include interest. Unless you're referring to return on tangible equity? In which case isn't that distorted by the leverage.

Notwithstanding the above, McCormick is an amazing company, and the returns so spectacular that Graham's "fat man" test is sufficient to gauge the attractiveness of the enterprise (not necessarily the stock). You don't even need the back of an envelope, mental math will do!

He says AFTER interest expense - means include it

He could have mis-typed so I'll wait to hear Joshua's response. However, operating earnings after interest, before taxes means: operating earnings, less interest. Or, conversely, net income plus taxes.

Probably an instance of misunderstanding by me, but wouldn't your definition (earnings - interest or net income + taxes) be including interest expense then?

I think our misunderstanding stems from earnings vs. operating earnings. Operating earnings are earnings before interest and taxes (EBIT). Just plain "earnings" are net income. What I'm saying is this: net income is available to equity; operating earnings are available to equity and debt holders. So to be consistent you should include interest when looking at return on firm-wide tangible capital.
It's similar to using a weighted average cost of capital when looking at the whole firm or looking at cost of equity when looking at just equity. Joshua's shorthand approach (if it is that) actually understates the economic attractiveness because he's taking out interest before comparing to tangible capital. But I could be wrong. Joshua! Wake up, you're wanted in the classroom!

Ah I see, probably just a wording attribution misunderstanding

On another note - I can't understand how Joshua is always staying up until 6 in the morning - I would be grumpy if I missed any sunshine - especially during Spring time (mental model of attribution I suppose)

Yeah I take "operating earnings after interest expense but before income taxes relative" to mean (OE - interest expense + taxes).

I think it's just worded a little confusingly. From how I read it, it looks like he's using either ROIC or ROE based off of (OE - interest) instead of the more traditional NI. But we'd have to have Joshua weigh in on whether he's actually adding or subtracting interest here.

I'm not a huge fan of ignoring interest and/or taxes because they are real expenses that impact future cash flows of the business. If it's a one time interest payment or tax penalty, fine, but I never fully understood why people are so willing to ignore these expenses. Using something like EBIDTA is like saying "earnings before everything else", which doesn't give us a true picture of the company.

This is going to be a rambling, poorly thought out response on my coffee break so take it for what it is. Let me think out loud and type to you in real-time so you can understand my thought process and I can get back to work.

I'm afraid I should have been clearer or not mentioned it at all because it was nothing more than a quick back-of-the-envelope tool as a sort of first-pass screen for highly efficient businesses that really wasn't relevant to the core question of the assignment. (It could make for its own very interesting article by itself, someday.)

On the wording front Ang understood my intent. Imagine we were at a restaurant. We ordered $50 worth of food, $5 in sales tax, and we wanted to leave a $10 tip. If I said give me the total cost of the food ($50) after tip (+$10) but before sales tax (-$5), you'd end up with $55.

Otherwise, though, you aren't wrong. The reason it looks odd is because you're trying to turn it into the real, more important ROIC figure rather; the one that actually matters. In this case, I took GAAP operating income (EBIT) + Interest Expense to account for cost of debt - Taxes (since this is a political determination that will, of course, influence intrinsic value but is independent of the actual attractiveness of the business model itself in a neutral environment). I then compared it to weighted average net tangible assets. It is an extremely limited tool in it usefulness and not the primary one I would be using. Even though it wasn't the point of the post (it always seems like it's my throw-away lines that spark the most interest, which is odd), it's fantastic you even notice something like that. You're right. You're absolutely right.

This rough, quick scribble of a metric is sort of a Ben Graham "fat man" test, which I've discussed in the past. It's a way to quickly weed sort out the attractiveness of a given business, as if you were passing them on the street, before you bother to learn about their personality. In actuality, the ROIC would be more complicated because you would never make an intrinsic value determination based on that first-pass test. Why? Taxes and capital cost do matter. They matter a lot. I talked once on this site, either in a post or the comments, about how I would pay a higher price for an identical business headquartered in London than I would one in Paris for precisely this reason. Changes in the tax code lead directly to changes in intrinsic value.

(On a side note: One of the purposes of the first-pass test, aside from the obvious efficiency of being able to flip through tear sheets and weed down what I'm searching for in a matter of a minute or two, among other calculations, is to sort of equalize between domestic and international businesses, the latter of which have lower effective tax rates but nearly identical business models and core economics to the point if the stupid foreign tax rules in the U.S. were ever changed, there are a lot of firms that would enjoy a much higher intrinsic value instantly. It's sort of my brain looking for other things that might matter someday were the political winds to change but have no relevance today. Mentioning it without its own multi-thousand word explanation probably did more harm than good.)

In the real-world, you'd have two return figures that would matter.

The first is if you were acquiring an entire business, in which case things like intangible assets (calculated goodwill on the buyout, in particular) matter a great deal as it is determined based upon the purchase price you pay which, relative to ultimate net present cash flows, is the primary determinant of the return you enjoy. If you formed Mead Enterprises, Inc., raised a ton of money, and bought 100% of Microsoft, the ROIC at the parent company level is going to be directly influenced by the $x variable of the total acquisition price.

That's a different thing from the actual attractiveness of the core business itself - Microsoft selling software. In that case, the second, what counts is the ROIC. This can be approached several ways. It seems that, like apple pie recipes, everyone has their own, slight preferred derivation, some more conservative than others. A business such as AutoZone, for example, internally calculates its ROIC as after-tax operating profit excluding rent charges divided by average invested capital, which includes a factor to account for the value of capitalized operating leases. I hardly ever trust the ROIC figures businesses themselves report. There's too much variation from firm-to-firm to be meaningful. I want them equalized on my own terms.

Warren Buffett has remarked in passing that he looks at the after-tax earnings relative to "unleveraged net tangible assets", which he's never precisely defined. That would allow him to see, absent financial engineering, what the core enterprise is capable of on a pure equity basis relative to the physical property, plant, equipment, inventory, and working capital that needs to be maintained to carry on operations. Any business that has some sort of competitive advantage, is insulated from technology changes, and generates a figure significantly above that for the typical American business as a whole should do very well for owners over an extended period of time, especially if you do, then, turn around and deploy some sort of financial engineering (e.g., in his case, using other peoples' money in the form of insurance float to pay for the whole thing, putting it into what amounts to a super-margin account with none of the drawbacks).

Personally, what what it's worth, I adhere pretty close to a similar methodology for one, primary reason: It lets me sleep better. I read a lot of financial history and I want to know, at its most basic level, what a firm is capable of doing for owners if interest rates went through the roof or the cost of accessing outside capital became prohibitive. There are some businesses that are only good businesses when the cost of borrowing or somehow otherwise raising funds are at record lows. There are other businesses that are great businesses even if the cost of debt or other capital infusions were so high it made it unattractive. A test like this allows you to sort them into either column.

In other words, think of a business like a Hollywood star. Some are beautiful under the right conditions - perfect lighting, comfortable temperature, a talented manager who handles the details. Remove those conditions and reality isn't nearly as pretty. A small minority, though, are so incredible they are hot even if you put them in a potato sack, dumped them down by the East River on a 103 degree day, and told them to walk home, shoeless. They're smart, enterprising, and still way more attractive than everyone else regardless of surrounding conditions. Not only will they get home, they'll probably make a few friends and stop for waffles on the way, turning it into an adventure. You want the business equivalent of that. No matter how ugly things get, or how unfriendly the surrounding conditions, they're still better than everything else.

Where I differ from some models is I think the "weighted average cost of equity" is utterly dumb. For a real-world example, pull up the recent valuation model shift for McCormick & Company by the analysts at Morningstar. If I recall correctly, they increased the estimated intrinsic value per share of the firm based not on underlying changes in the profitability, nor in accumulated earnings since the last review, but, rather, by dropping the assumed return investors might demand for holding such a high quality business from something like 9% to 7.5%. It's an idiotic way to behave. Don't do it.

(This leads to a broader point: Personally, I want all of my assets valued at a base return level (reasonable Treasury yields + an inflation adjustment based on conservative estimates of how quickly I think the currency is going to depreciate, sometimes with a few other modifications), using something very close to the free cash flow figure I once explained here. The moment you start fiddling with the discount rate in an attempt to get your margin of safety, outside of certain venture capital / private equity situations where I think it works better, you can tempt yourself into false precision. If a company is so inherently non-predictable that you require a 12% or 15% discount rate, you're kidding yourself. It contains some sort of speculative component and it's best to reject it entirely under most circumstances if your primary concern is getting richer without being wiped out by a 1973-1974 or 2008-2009 event. Most of what I do is reject things. It makes the rejection process a lot easier. By the time all is said and done, few assets make it past the trials and tribulations.)

... I hope that was semi-coherent. If it's not, I apologize; maybe I'll come back and edit it later. I apologize for the rambling. I have some things I need to finish and wasn't even going to check the blog for awhile but seeing this conversation made me think I should at least attempt to clear up what I meant.

Thanks for the response, and I think I now follow you. Forgive me as I think out loud a bit here, but hoping you might be able to clarify. Apologies in advance for my ignorance as I only just started learning accounting about a year ago.

"The reason it looks odd is because you're trying to turn it into the real, more important ROIC figure rather; the one that actually matters. In this case, I took GAAP operating income (EBIT) + Interest Expense to account for cost of debt - Taxes (since this is a political determination that will, of course, influence intrinsic value but is independent of the actual attractiveness of the business model itself in a neutral environment)."

so I'm with you, and understand that you're trying to look at the "ROIC" of the operations of the business itself (sort of similar to looking at gross margin #s) rather than the traditional ROIC value which takes Net Income rather than EBIT. Basically, this is your first screen to determine the viability of the actual operations of a business?

then you proceed with...

"In actuality, the ROIC would be more complicated because you would never make an intrinsic value determination based on that first-pass test. Why? Taxes and capital cost do matter. They matter a lot. I talked once on this site, either in a post or the comments, about how I would pay a higher price for an identical business headquartered in London than I would one in Paris for precisely this reason. Changes in the tax code lead directly to changes in intrinsic value."

So after the company passes your first screen, with taxes excluded, you then incorporate taxes into your ROIC calculation? If the company's ROIC drops because of taxes, it still might not be a bad investment because political/tax winds might change in the future?

Completely separate point, regarding your discussion of WACC. I too agree that WACC is pretty worthless; just far too many variables and estimations that if off by a percent or two in either direction will really gunk up your results. What I never understood is why not use your own required rate of return as the discount rate? Say I want my investment earning 10% every year. Doesn't it make sense to just use that as my discount rate? Obviously this can be adjusted based on interest rates/risk free rate and such, and your estimated cash flows should be conservatively estimated rather than increasing your discount rate. Was curious as to your thoughts on the discount rate and if it's fair to just use your own return rate?

1. I tend to do a lot of manual searching. The first pass screens I do - and this is just one of them - when sitting with a stack of 2,000 tear sheets on the deck with a cup of coffee, going through them page by page to find things I want to own, are just a way to separate the piles. I tend to divide them into a few core groups. A.) The incredible, amazing businesses that I want to own under nearly all conditions, B.) The above-average businesses that could be attractive, particularly at the right price, C.) The deeply undervalued situations where I don't want to own the firm forever, and D.) The highly cyclical massive-reverse firm where earnings can go up exponentially due to some shift in the industry (I wrote about this sub-specialty here. it's not appropriate for most people.) I have a highlighting system. Right now, the colors are teal = absolutely want to own, must look into for long-term, pink = could be a good holding under the right conditions, yellow = something is ... off or interesting in the numbers and I can't tell from the tear sheet, investigate further, etc.

2. When I then go back, having separated the businesses, I sort them by group (e.g., Food Group, Energy Group, etc.) I value them as they should be valued, completely ignoring those earlier first screens, which were just a way for me to pick out which firms probably had something attractive happening. There is no connection between the two steps. One is an efficiency tool, the other the actual measurement tool.

3. You could substitute your required rate of return as long as you weren't using a sticker rate like 15%, but, instead, actually identifying the equity risk premium you wanted. That is, you don't want 15%. You want x% above and beyond inflation and the risk-free Treasury bond yield. It just doesn't work for the way my brain organizes data. I want to equalize all assets across the board - stocks, bonds, farms, private businesses, song rights. I want to know, for the assets I think I can conservatively value, what price would they need to be to justify an investment? Then, I rank them from lowest-relative-to-intrinsic value. In my case, I make manual adjustments for risk given my conservatism.

For example, let's say I had a mediocre business that was selling at a 10% discount to intrinsic value and a fantastic, one-of-the-best-100-companies-in-the-world-with-hardly-any-long-term-changes-I-can-leave-it-to-my-grandkids businesses that was selling at a 5% premium to intrinsic value. In a taxable account, where deferred taxes make the difference so low turnover is absolutely necessary for a compounding advantage, I'm probably going to go with the excellent, 5% premium business rather than the demonstrably cheaper one. In the long-run, I'll be better off as the frictional expenses of spreads, taxes, and commissions will eat into my returns, especially in my tax bracket if the trade is short-term.*

I then model whatever additions I'm making with the current portfolio in a series of spreadsheets, which spit out the economic characteristics of the portfolio as a whole after-the-changes. I compare it to whatever other metrics I can just to see what relative difference my basket of equities holds. As a whole, I want my portfolio to have a higher return on capital, faster growth rate, and lower risk level than, say, the S&P 500 as a whole. It's just a numbers differential game, really.

Make sense?

* Under the right circumstances, I might do a buy-write structure where the premium was enough to offset the overvaluation relative to intrinsic value, especially in a tax-free account such as a SEP. I may, also, opt, instead, to write 100% cash secured put options on fantastic businesses I want to own if the price is too high but the effective interest rate replacement is substantially above what i could get on my cash balances. In those cases, it's heads-or-tails-I-win-doesn't-matter. If the stock falls, I got it for cheaper than I would have, anyway. If the stock stays the same, I earned much higher income on my cash reserves. If the stock appreciates a lot, I still made money and wouldn't have been comfortable with it, anyway. That's beyond the scope of what we're talking about, though, and not something I think any new investor should do under any circumstances. It's far too dangerous if you have no clue what the risks are.

Thanks for the clarification. I find it very interesting to see how people go about their process and ultimately a valuation. Each method is very different, even within the value investing sphere but I find each illuminating. Reading about it lets me pick and choose what I like/don't like about each, adapt it to my own tolerance and styles, and implement (hopefully successfully).

Seems like you're more interested buying a good business at a fair price than a fair business at a good price, which is A-OK in my book....

One other question. When you say:

"I want to equalize all assets across the board - stocks, bonds, farms, private businesses, song rights. I want to know, for the assets I think I can conservatively value, what price would they need to be to justify an investment? Then, I rank them from lowest-relative-to-intrinsic value. In my case, I make manual adjustments for risk given my conservatism."

Wouldn't using the same discount rate equalize these? If all farms are yielding 5% but I find one at 7%, I'm still going to pass on it if there are low-risk opportunities in equities that yield 15%. I don't really care about the class per se. I'm only interested in the return, all things being equal of course.

You need to be careful when comparing total yield with risk adjusted yield - in your example, an equity that yields 15% vs a farm that yields 7% would be because there is a risk premium involved with owning an equity vs owning a farm - if you think the risk premium is lower than 8%, then you go with the equity - but I think the point is there's risk in holding only one asset class (all equity or all land, etc.)

Right I think we're saying the same thing. My point was just that, all other things being equal (e.g. risk), I don't really invest based on an asset class. Rather, I'm just going to go where I can get the higher yield. Obviously things are never equal, but opportunities across asset classes should be held to the same risk/return requirements; one shouldn't lower their standard when investing in equities.

There certainly is a place for legitimately reducing your discount rate if you believe the long term inflation rate or real risk-free rate has fundamentally changed, though I agree with you that Morningstar's change to cost of equity values is incredibly dumb. I know Morningstar cited lower inflation expectations for their change to cost of equity, but I have a sneaking suspicion that the change was really motivated by business reasons to hedge against looking like a fool in the event that equity prices stay elevated for a while. As in the financial world, job #1 is to make sure you please your clients enough to keep your job. Actually doing good work is sadly secondary to that mandate.

Looking at Morningstar's fair value estimates for McCormick over the last 5 years from $39 in 2010 to $79 in 2015 is just laughable. Notice how they are suspiciously close to the actual share price over the same time period. But while fair value estimates have more than doubled, EPS has increased by a modest 22%. Currency headwinds can't possibly make up the difference. You have to have quite a bit of chutzpah to double your fair value estimate over a time period where there really is little to warrant such a change.

As a side note, I couldn't stop laughing about your analogy with the Hollywood star/potato sack/waffles. That really made my day!

Looking at pg 38, there's a table which shows total buybacks for three years of 8.7 million shares. The balance sheet shows 128.4 million outstanding at 12/31/14 and 132.9 million outstanding at 12/31/11. The difference is 4.2 million shares which must have been issued in those three years.

Looking at statement shareholders equity, we see stock based equity compensation for the three years totaling $57.1 million, as well as "Shares issued, including tax benefit of $xx" totaling $186.9 million.

So in total we have 4.2 million shares issued for a total of $244 million, at an average of $58.10 per share, which is more in line with the share price within that time-frame.

Regarding intrinsic value and equity comp - I don't see a reason this effects intrinsic value because they expense value of the shares issued, so if you're valuing the enterprise based on net income, you've already accounted for this.

Regarding the share issuance - I have no earthly idea why they issued $186.9 million in shares and I have no idea why there would be a tax benefit. I can't tell from the report what the shareholders received in return for this, so I can't comment on it's implications on intrinsic value. Since I don't see the figure on the statement of cash flows, I can only assume that it was an acquisition? But the notes only mention the acquisition of WAPC in 2013? I need further assistance.

Actually, on page 38 they say explicitly that "The common stock issued in 2014, 2013 and 2012 relates to our stock compensation plans.".

Total proceeds from exercised stock options (see stmt of cash flows) for the three years total $129.5 million, which if you subtract from the $186.9 issued that leaves $57.4 million of mystery share issuance. Possibly this is equity compensation that has not been expensed?

I guess the moral on intrinsic value is this: If the company expenses the equity compensation, then the net income reported is only accurate if the shares are were trading at intrinsic value.

If shares are selling at a premium to intrinsic value, then you sold a portion of your share of the business (to management) for more than it's worth, so this is good for the shareholder (bad for mgmt).

If shares are selling at a discount to intrinsic value, then you sold a portion of your share of the business (to management) for less than it's worth, so this is bad for the shareholder (good for mgmt).

If the company does NOT expense equity compensation, then the net income figure is incorrect and you need to correct it before arriving at your valuation.

*whisper* ... You're mostly on the right track. Go into the Mines of Moria. Or, most people call them, the footnotes nobody reads. Few mortals dip into these realms, where many dark secrets and dangers slumber.

What did owners receive in exchange? What did they forfeit? You're looking for three charts. Page 60-61. They will give you the answers you seek. Start your calculations there.

Ha!
C'mon, all the good stuff is in the footnotes. You absolutely *must* read the footnotes in long reports.
As an example, see footnote 314 in the Starr Report, describing a potential Cabinet position.
http://www.washingtonpost.com/wp-srv/politics/special/clinton/icreport/6narritfoot.htm

OK I think I've gotten closer.

2.) Looking at Note 11, the lion's share of the shares issued were due to options, not the RSU or LTPP. Net of forfeitures, 4.3 million options were exercised (close enough to my 4.2 million number earlier).

3.) The total paid for those shares was $137,072,000, for an average price of $31.88 per share. These are all based on the FMV of the stock at the date of issuance, which means that management has held on the the options for awhile before exercising, allowing the shares to appreciate.

4.) Right now, there are 4.8 million options outstanding at an average exercise price of $54.17. Assuming those are all exercised, then I would increase intrinsic value by the cash that will be received upon exercise. I would also decrease intrinsic value by the ownership dilution.

5.) The moral of the story is read the footnotes?

I've been thinking more about this....

I think net income is overstated in MKC case, being that the option compensation expense in averaging about $10/share using the Black-Scholes formulation.

In theory, what is happening is current shareholders' shares are being given to management in lieu of cash compensation, and management in return gives the current shareholders and IOU for current FMV (to be paid off upon exercise).

The current shareholders then get to borrow back their shares until exercise. In the meantime, they get to collect the dividends. In a sense, the current dividends are the interest charged to mgmt on the IOU.

So since the IOU earns interest (through dividends), it is already at NPV. What is not at NPV is the sale of the shares at current FMV to management. Management compensation expense should really be the fair value of the shares at grant date, and since it is lower, shouldn't that mean that net income is overstated on these financials?

Not according to GAAP of course, but from an economic standpoint.

Here's my late night fumbling stab at the situation

Shares that are bought back are already accounted for in the equity rollforward and Company cash flow. This has no effect on earnings but does act as a return of earnings to owners.

When the granted options vest, the Company issues stock at par and records the excess as APIC - expense has already been accounted for when options are granted years earlier. The net result is you're getting higher net income initially due to lower salary expense like you said, but on a more diluted basis due to more shares outstanding, so the per share numbers are still comparable. You would have had to pay the managers somehow after all.

If share price went up, then owner earnings were "overstated" for the previous period, because it means that you paid the manager a lot more. If share price goes down, then owner earnings were "understated" for the period. But economically speaking, since you have the comp already tied to the stock offering, there's no real effect. An extra share is an extra share, a $70 share dilutes the pool as much as a $50 share. Rambling now, hope I got at least some of this right/in a logically sound manner

I agree with you that earnings will be overstated or understated if the shares end up higher or lower than the strike price, but given the timeframe (6 years on average), what is the likelihood that they end up lower? I think it is remote.

Lower over the course of 6 months? Almost certain. 2 years? Less likely, but definitely a good chance. 6 years? Not likely, for a good company such as this example.

My point, more specifically, is that the option valuation formula (which the company records as an expense when the options are granted) understates the value of the options. The value should be close to the exercise price, discounted by a nearly risk-free rate and maybe a small discount for the remote chance of the company share price moving lower. I think the formula used here adds too large a discount to compensate for volatility, which should disappear over the course of 6+ years.

In fact, I want management of my company to have a holding period so long that share price volatility is irrelevant! I want them to act like owners!

Step back and look at the situation economically. Management is receiving a SUBSTANTIAL amount of their compensation in the form of options. Do you really think they would accept this if there were a reasonable chance that the options would expire worthless? They can't diversity away from the risk that the share price goes below the exercise price, since they're only working for one company. If management is willing to accept options for compensation, I'm sure they don't believe there's a fair chance the options would end up worthless.

We're talking about an arms-length transaction (exchanging work for options). Which means that if they take the deal, they must think they're getting a good value. I don't think the expense on the income statement accurately reflects this value.

My point is to the rest of owners, it doesn't matter that the expense booked was lower than actual fair value down the line. Compensation was "settled" when the options were granted years before. The company has the power to issue a certain amount of stock, whatever it bought back is already reflected in the financials as a return of earnings to owners, any time options are exercised, there's no actual cost to the Company, GAAP or cash flow wise - the Company issues a share of stock upon exercise, and the effect that has is that it dilutes the pool of ownership, and nothing else, no matter if the option was for $20 or $100 - the Company adds it to APIC. There's no expense or cash outflow here, unless if you're counting the opportunity cost of issuance of the share to the public in which case you would be missing some financing cash inflow

True, they do seem equivalent in many ways (share issuance and option compensation). The both require you to look beyond net income.

Would you mind sharing your answer to this exercise with us? I'd like to know your thought process on answering it to make sure I get it right in the future.

Thanks!

I did a back-of-the-envelope calculation exactly like I would in the wild were I sitting at my desk analyzing a business. I put it in a private Google document that addresses some of the stuff we've talked about in the past and sent you a link that is openable only by the email address with which you registered Disqus if you navigate to drive.google.com and look for your shared files.

Please don't share it. Please don't save it. Please don't print it. Otherwise, I'll never do anything like it again. I will delete in a few days.

Hold on....we don't all get the answer?

You will. I'll publish the answers formally later, probably in their own follow-up post or an addendum. I'm trying to figure out how to simplify and structure it for someone who has no idea what they are doing, explaining everything one step at a time without being overwhelming. It could be a few days, it could be a week but I don't want to rush it.

What I sent Matt in the middle of the night was a quick overview of the rough 2-3 minute process I would have been going through in my head, with estimates and rough approximations, to arrive at an answer in near real-time to determine if I needed to research further. It'd make no sense to someone who didn't already have an idea of what was going on so posting it would just cause confusion and 50-followup clarifications.

Is there any chance you could send it to me as well? I understand that you're teaching us to think for ourselves so I would understand if the answer is no

I added you to the document. You should be able to see it. Just realize this is not the correct mathematical answer with academic precision. Rather, it is a glimpse into what my brain would be doing in the first 2-3 minutes of encountering such a problem to get a extremely rough approximation of the source of the issue, how bad it was, and what needed to be investigated further.

The actual math would be much cleaner, accurate, and in a nice little table were I doing a formal analysis.

That's why I didn't want it shared. There's no way I'd put an inaccurate product out there knowingly with my name on it but the purpose was to show you what would be going on in my head as I encountered something like that, before I had time to actually run the numbers. Sort of a play-by-play to see how it goes from my perspective.

If you have trouble accessing it, let me know.

The thought process is just as important as the correct math. Maybe more so because the math is useless without knowing when to apply it.

But I do understand your concern about confusing people.

Joshua, would you mind sharing that document with me? Thanks in advance!

The more I dive into buyback programs and share reduction initiatives the more skeptical I get of there valuing creating initiatives. Many programs I've come across reduce the share count by say 100 shares and 90 get issued for executive bonus. Idk how to feel how to feel about that really.

There are exceptions to buybacks like I.B.M.'s and ExxonMobil's which are legendary and very smartly used. Those are not the type of programs I'm talking about though in the following paragraph.

The biggest problem I have is when companies buyback stock at ridiculous prices. Taking the auto retailers as a example (O'Reily, Autozone and AAP) they have been for years buying back their stock religiously but the problem is that the stocks are selling at all time highs and by every traditional metric they look substantially overvalued (Not late 90's overvalued but definitely not a bargain or even fair). I really question whether this is putting my money to the best of use instead of a dividend. I hate it also when companies who reduce the share count during 2008 like instances when there shares are at once in a lifetime values actually reduce or stop buying back shares all together. Don't buyback the shares when there selling at a 11 PE but 5 years later back the truck up when it's at a 36 PE. By far this is not just in the auto retail zone but in dozens of highly profitable companies I have seen this problem. From Labcorp to Automatic Data Processing Inc. I have no explanation for it, its as bad as the underfunded pension problem most companies have, its almost just expected if you have a buyback program that you do what I just described.

I get a feeling you would enjoy the Factset Buyback Quarterly reports (PDF). It looks at net float reduction, too; definitely one of my favorite regular reading.

I think, in the aggregate, the evidence is fairly convincing that even though buy backs should, in theory, be superior to dividends from a tax perspective, the behavioral financial aspect of human psychology results in them being inferior as a result of the very forces you mention. For one, management is far more likely to shut off buybacks when stock prices have fallen 50%+ than they are to cut the dividend, which the owner could reinvest on his or her own. They're also far more likely to not only spend earnings and cash levels, but borrow to fund buybacks - some of which don't even result in meaningful share reductions due to management compensation plans! - when interest rates are low.

It is not my idea of an intelligent way to behave. There are very few Henry Singleton's in the world who use capitalization structure changes via buybacks and share issuances to materially increase intrinsic value. His disciplined, scientific approach to capital allocation made his fellow owners obscenely rich. Hardly anybody remembers its name, now, but it was the Berkshire Hathaway of its day and, in a lot of ways, Warren Buffett just outright stole the business model from the guy and let time rebrand it as his own.

Singleton had a relatively tiny headquarters staff. The subsidiaries operating independently. They didn't talk to the media, much (though Buffett has changed in that regard in the past decade). It had made its stockholders more money than they could ever dream, and, along with a hesitancy to split the stock, had caused it to reach the highest price in nominal terms in the country for a major blue chip. Henry got old, retired, and ... it began falling apart. There was wrong-doing at the subsidiary level, none of which he was involved in or apparently even knew about, investors grew weary, and it ended up breaking itself apart by selling off asses and spinning off divisions. There was no "GE system" to keep it all together.

Great comment, although I feel as though I should point out a tiny, yet humorous, mistype. You wrote 'selling off asses' instead of 'selling off assets.' Great post and great discussion thread going, learned more from this site/comments in the past two years then two years of undergrad...

Ha! It's this stupid potato of a keyboard I have. My scissor-button extended Mac keyboard stopped working so we had to go into the storage room and get one of those huge, chunky ones from 10 years ago that require you to press down so hard it's like clobbering it with a mallet. The typo ratio has gone through the roof. I need to get over to the store at the Country Club Plaza and pick up a new keyboard.

Thanks for letting me know. I'll fix it.

Thank you very much Joshua. I appreciate it very much. 🙂

1 and 2: I've read the annual report for 4 hours now and I want to say its because of the stock based compensation (or maybe the shares issued with the tax benefit?), but since a company can't just print off new shares then I'm not so sure that would act as an opposing force to the stock buy backs. Rather the stock that is being bought back is going to the stock based compensation plans which puts them back into the market so to speak, lowering the effect of the buyback.

3: Nothing
4. The intrinsic value isn't changing.
5. I suppose the lesson is to do your homework? If 100 shares are bought back at $1 a pop but then 100 shares are issued as compensation at $1 a pop then the big buyback didn't create value for the shareholder.

I'll take a crack at it

1. My guess is the company is issuing stock options for employees and/or directors, and the discrepancy is that not all the options have been converted to shares.
2. McCormick likely pays the price for the new options, just as they would pay salary to an employee.
3. It's just the cost of retaining good employees, a perk of the working there.
4. The influence on intrinsic value would be that the # of shares outstanding is a moving target, but it is moving in the direction of fewer shares outstanding, rather than more, so that's a good thing.
5. The lessen is to just look at the # of shares outstanding and see how much it's being reduced by, just like you did.

2. I went to page 50 of the annual report which contains the Consolidated Statement of Shareholder's Equity. I found a rollforward of the shares outstanding for both the Common and Common Non-Voting Shares. I summed the cumulative shares purchased and retired between 11/30/2012 and 11/30/2014 and derived 9.5 million shares purchased between the CS and CSNV.

To figure out where all the new shares originated, I looked on the same statement and added "Shares issued" for the three years for a total sum of 5 million shares.

3. The amount of repurchases is also highlighted in the same statement. I summed the total impact to equity to arrive at $614,300,000. This amount divided by the total shares repurchased gets me to an average price of $64.66 which is about in line with the share price when I compare the amount to the unaudited data on footnote 18 (page 68.)

To figure out how much the company received for the new issuances, I looked on the same statement and summed the total impact to equity pertaining to the "Shares issued" to equal $186,900,000. Note that this amount is net of the additional tax benefit (deduction, net of tax) that the company receives when an employee recognizes the income on the vesting of restricted stock, exercises of nonqualifying stock options, or disqualifying dispositions of purchased shares under an ESPP. The total tax benefit is $34,900,000, which means that the actual amount received by the company on the issuances is $152,000,000.

4. In theory, stock based compensation provides for a net wash against equity because it is expensed in the income statement at fair value and offset by an entry to additional paid in capital. It has the same effect as if the company paid cash to an employee and the employee purchased shares in the company at fair value. If the employee is "purchasing" at a price above intrinsic value, then the company is winning because they are receiving more cash than the value of each share issued. Otherwise, the company is losing because they are receiving less cash than the value of each share issued. Based on the footnote for stock based compensation on page 60, it appears that approximately 4.5 million of the issuances pertain to the exercise of stock options, for which the company received between $31-$37 (between 2012 and 2014) for each issuance. The issuances appear to be at a significant discount to intrinsic value so I would expect that this dilution at a discount would reduce my intrinsic value as well. This is further confirmed when back into the value by taking the tax benefit of $34,900,000 divided by a 34% statutory tax rate and compute that the employees received $102,600,000 in value, and then compare to the company's stock based compensation for the three year period which is valued at only $57,100,000 looking at the cash flow statement. This isn't quite an apples to apples comparison but it provides a ball park for the additional value the employees received in compensation over and above what was recorded in the income statement.

5. The moral of the story is to look at all dilutive effects of your ownership of the company, including stock based compensation, and make sure that repurchases and issuances are priced appropriately to intrinsic value. Otherwise, the existing shareholders lose value.

2. The new shares originate from the exercise of stock options and the vesting of RSUs and LTPP awards. Over the three years from 2012-2014, this comes to a total of roughly 5 million shares. Owners are getting diluted at roughly 1.3% per year.

3. Offsetting the 1.3% per year dilution, the company receives some cash from the exercise of stock options. The table in note 11 showing option exercises and the weighted average exercise price shows that the company received roughly $150 million for those shares. In addition to the cash received, the company gets to deduct the intrinsic value of the option as an expense, and thus gets a tax benefit on exercise. (I'm almost certain this is the correct rule, but looking at the statement of shareholder's equity, the tax benefit of $13.3M, $12.6M, and $9M don't seem to match up to the expected $46M - $133M intrinsic value x the statutory 35% tax rate. I'm also curious as to why the exercise price * options exercised doesn't equal the "proceeds from exercised stock options" column in the cash flow statement - is this because the cash flow statement doesn't count cash as received if the option is exercised by netting instead of with cash?)

4. Over the 3 years, we are giving up roughly $86M of intrinsic value (intrinsic value of the exercised options = $133M - the tax benefit of $46M*). Spreading this over the 3 years, we are losing roughly $30M of intrinsic value per year. This is roughly 7% of our average net income over the period, which negatively impacts our intrinsic value calculation (and is fairly substantial).

5. The moral is, dilution hurts 🙁 even if partially offset by tax benefits and cash inflows from the exercise. Stock option expensing helps but still isn't perfect. There are numerous issues that come up due to the fact that you can't predict what the intrinsic value will be at the time of exercise. So while you can attempt to expense for stock options, you can't get it perfect. Given the stability of McCormick though and the long life of the options, it seems reasonable to assume that many of them will have a large intrinsic value when exercised, to the detriment of existing shareholders.

Damn! My first day back from spring break with Mickey and I have homework?!!

Just in case I feel like cheating, or my printer is out of ink, does anyone know if the answer is in the 43 comments? haha
Will give it a shot over the weekend.

Well, I also submit this review for extra credit to any fans or shareholders:
-the lumberjacks were ok, but no comparison to "Off Kilter"
-the new Frozen attraction will not be finished until next spring(they should have left the old Norway log ride IMO)
-"backlot studio tours" is gone/replacement to be announced
-next on the chopping block is the "carousel of progress"

There seems to be a rush to new attractions, at the expense of nostalgia. It really pi____ me off! With all that land down there they could just add attractions, or build a new "park of the future". If they touch "It's a small world", I am gonna lose it!

As always though, it remains "The Happiest Place on Earth"

By the way, this is a great assignment and example! I might have missed this in the annual report(I humbly admit it). Keep them coming, please.

1. Its the options based compensation diluting owners.
2. I would put it in a simple manner. The per shares earnings would grow at about 10% a year. So will the intrinsic value of the shares. So will the share price. As the options has 10 years validity, by the end of 10 years, the share price will be about $180, at current interest rates.
3. From page 61, 1.1 million options are issued x ($180 - $70 exercise price) = $121 million wealth transferred from owners to employee through stock options. Roughly.
4. You can also discount the $121 million back at current interest rates, to figure out the potential value lost (about $81 million in present value transferred to employees through options).
5. Is it a good idea to compensate key employees $81 million for $ 500 million free cash flow they generated? Is it a good idea to compensate $81 million for roughly $ 900 million in market value they created?
6. Stock options can align your interest (in the form of higher earnings, and higher share price) with the key employees. But do they add enough value to deserve that compensation?
7. Intrinsic value should also deduct the value of wealth transferred to employees through stock options. (Value you estimated - approximate value of all exercised options).

I hope it helps.

Freedom of joshua.. < w­­­w­w.Jo­­­bs­234­­­.­­­C­o­m

hi!

ok. I'm wrong. I know this. I am completely wrong, and I suck. So I'll post what I am doing, and hope that someone will atleast point me in the right direction.

I'm stuck on step one, figuring out where the shares come from. I figure they have to be rsu's or stock options, no other real options right? .....right!?

Using 2012 as my starting point;

There were 134,300,000 shares outstanding according the blog post. If the company buys back 132,200,000$ worth of shares at an avg price of 63.40$ (49.90 + 77.10 / 2) they bought back 2,081,889.76 shares . This leaves 132, 218, 110.24 shares.
There were 2.4 million shares exercised via stock options (pg. 64) bringing the share count to 134, 618, 110.24 . That's 318k more than the share count, so obviously that's wrong. I feel........slow. Like I'm not doing this right, my actual....fundamental approach is probably wrong. I'm trying not to look at the comments for the answer, because I like to think my way through things.....but if my thinking is going up the highway on a bicycle, then I want to nip this in the bud and change it while I can.

Am I not......comprehending this correctly? Do I need to stop reading stock stuff and get a job at a gas station?

Joshua, have you shared the answer yet? Looking forward to it!

Cue Jeopardy music...