Stock Options accounting and the Value Investor
I know it seems as though this issue is both murky and seemingly largely unimportant in the overall scheme of deriving the fair value of most companies. However, in the next several posts I will attempt to show that sometimes how the stock options are accounted for can have surprisingly negative implications for the value investor.
The company I will use to highlight what I mean is DELL. This is a company that many would agree represents many good things about technology, business, and seizing new opportunity (the internet) and actualizing it to nearly its full potential for growth and profit.
If you will bear with me through this process, I think you may be surprised at the outcome.
As a value investor, I have been virtually salivating over the trend in stock prices because, finally, there may be some larger cap companies that will qualify under the rubric "value".
During my wanderings over the net last week I saw several posts that indicated that DELL's stock options, if properly accounted for, would result in negative earnings rather than the positives that had been reported publicly (unfortunately, I don't remember who posted or where, or I'd give them credit for bringing this to my attention). The first time I read this, I put it down to perhaps a short-seller with an agenda, and pretty well dismissed the notion. the second time I saw it, it was a different poster and some of the numbers this poster used were reportedly from the Statement of Cash Flows. Since this has been an area of focus for me over the last several years, I thought I'd do my own research and see what I'd discover.
Before I get into the actual numbers themselves, I'd like to address methodology. Both the common short-cut version and my own more detailed version.
The common short cut for determining Free Cash Flow(FCF) is Cash From Operations (CFO) minus CAPEX.
For those unfamiliar with the Statement of Cash Flows, before your eyes start glazing over, let me just give a quick refresher of how we get to CFO. The starting point is the Net Income reported as the bottom line on the Income Statement. The Net Income is adjusted to remove all the non-cash items imbedded in the Income Statement (like Depreciation, Amortization, reserves accounts, etc). Once these adjustments are made, the answer derived is called "Cash From Operations" and is supposed to represent the cash earnings of the company for that period.
So, to recap.....
The common shortcut formula is: CFO - CAPEX = FCF
This short-cut will work most of the time, but for a company that wants to mislead investors and analysts and knows how widespread the short-cut usage is, there are other ways to report the numbers that by-pass this shortcut. Whether what DELL did is intentional or not, I cannot say. The impact of their methodology, however, makes me suspicious.
The way I calculate FCF is by starting at the bottom number of the Statement of Cash Flows and moving up through the "Results of Financing Activities" and the "Results of Investing Activities" backing out all non-operational entries, such as money received from selling stock or borrowing money or selling land and equipment. I also add back all deductions for the optional uses of cash like paying off debt, paying dividends, and buying back stock for the treasury. Theoretically, the number I derive using this method should be the same as the number derived from using the short-cut formula. In the case of DELL, it is not even close. How many other companies might use similar techniques I don't know, but this analysis has certainly opened my eyes regarding the possibilities.
I know these posts will be longish, but I hope to give enough insight into the issue to stimulate others to research this aspect of the financials prior to making investments.
Timba |
