LON:ABDP | Share-based Payment Costs - ABDP Case Study

26th Apr '17 by Effortless Cool

8 comments 6791 reads

Based on Paul Scott’s analysis of ABDP’s recent interim results and the ensuing discussion, there seems to be a poor understanding, even amongst savvy investors, of the methodology through which share-based payment costs are calculated and the appropriateness or otherwise of including them in earnings-based valuations.

http://www.stockopedia.com/content/small-cap-value-report-tue-25-apr-2017-bltg-cpr-abdp-180864/

I was one of those confused investors, and the ABDP situation spurred me on to do some research to properly understand the share-based payment figure and to assess how share-based payments should be dealt with in a valuation process. It is the conclusions from this work that I am sharing here.

First, by way of background, On 11 July 2016 ABDP granted 1,337,122 options to its employees at an exercise price of 395p. One-third of the options granted vest on each of the first three anniversaries of the grant date, subject to the employee remaining with the company on each vesting date.

http://www.investegate.co.uk/ab-dynamics-plc--abdp-/rns/new-share-option-scheme-and-trading-update/201607120700068545D/

ABDP published its interim results on 25 April 2017. The headlines were based on results excluding share option costs. They claimed a pre-tax profit of £2.5m, up 9% on 2016, and EPS of 11.04p, up 5% on 2016. The Income Statement showed a very different picture, however, with the pre-tax profit of £1.7m, down 29% on 2016, and EPS of 6.65p, down 37% on 2016. The reasons for these differences was £806k of share-based payment costs.

http://www.investegate.co.uk/ab-dynamics-plc--abdp-/rns/interim-results/201704250700081829D/

The starting point to evaluating the share-based payment costs charged to the income statement in respect of these options is to assess their “fair value”. This is effectively the theoretical market price at which an employee could have sold those options (if the rules of the scheme allowed it and if a market for employee share options existed – neither being the case) at the date of grant. It is calculated using the Black-Scholes model.

According to the ABDP 2016 annual results (note 22), the weighted fair value of these options was 197.19p per share. Thus, the total value to be charged to P&L in respect of these options is £2.6m (1,337,122 options x 197.19p fair value). At in excess of one-year’s pre-tax profits, this is obviously a huge amount for ABDP.

The charge against the income statement is accrued on a flat line basis over the period between grant and vesting.…

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shipoffrogs

26th Apr '17

"Given the above, I conclude that is entirely correct to add back share-based payment expenses to pre-tax profits and earnings per share when valuing a company. They are simply a piece of accounting fiction and should be ignored".

I prefer Buffett's take on this. If you give these warrants to employees - the company forgoes the cash it would have received had it, instead, sold them. - “Berkshire [Hathaway] will be happy to receive options in lieu of cash for many of the goods and services that we sell corporate America.”

Here's a good article on the subject: https://hbr.org/2003/03/for-the-last-time-stock-options-are-an-expense

rhomboid1

27th Apr '17

My rule of thumb is simplistic, if the scheme has a cash value to the employee then there is a tax adjusted equivalent cost to the company. The only question remains over the timing of the cost recognition, if the scheme is an effective motivation for staff (which most schemes I've seen up close are) then the revenue line is already reflecting that and thus a proportion of the cost incurred is rightly due along a similar timeline. I see no reason to back out the costs in the way the company have done

I sold Ab Dynamics (LON:ABDP) as a result , love the business but the rating demands a lot of growth that wasn't apparent enough in the adjusted numbers.

Rusty2

I have held Ab Dynamics (LON:ABDP) for over 2 years, it's a good company the sort I want to hold for a long time but I'm concerned about the share options, lack of growth and who knows what effect Brexit will have, so I have sold out this morning.

bestace

Buffett has already been cited on this thread, but I think this Buffett quote is more apposite:

“If stock options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world do they go?”

I think he's right. Of course they are a cost, and as such they need to be reflected accordingly in the income statement.

To my mind it only makes sense to adjust for them if you are trying to compare the underlying trading performance of the business from one period to the next, and even then only if the charge to the income statement is lumpy across different periods.

However if you are trying to get a sense of the overall profitability of the company, there is no excuse for ignoring the cost. Likewise if you are trying to compare situations where one company tends to remunerate its staff in cash and another in stock options.

Given the dilutive effect on shareholders, they are not just an accounting fiction and investors are deluding themselves if they ignore this cost when trying to value a company.

Twitter is an example of what happens when this is taken to an extreme. In its FY16 results, an operating profit of $158m turned into an actual loss of $457m once the stock options and other share based payments amounting to $615m are taken into account. To put that into context, the share based payments amounted to 24% of their total revenue.

By treating their shares like confetti, they have managed to increase the number of shares in issue by something like 35% since IPO, and that's not counting options issued but not yet exercised. How can existing shareholders possibly write off that effect as an accounting fiction?

hayashi22

Good posts. Having mulled it over AB is being removed from my watch list. It's a good company no doubt but more or less agree with rhomboid. I'm sure though they can attract the best by giving new hires a slice of the action so to speak.

Effortless Cool

1st May '17

bestace et al,

There is no argument from me that the issue of stock options represents a cost to the shareholders of a company. The point I am making (not clearly enough, obviously), is that it is not appropriate to use the fair value accounting cost of those options, as set out in the financial statements, in a valuation calculation.

The valuation of a share is based, essentially, on the net present value of all future cash flows divided by the number of shares in issue. The effect of exercised options on this value is to increase the cash inflows (due to the payment on exercise) and also increase the number of shares participating in those future cash flows. This is the true economic impact of the options, and these are the characteristics that need to be captured in the valuation methodology.

You might make an argument for including the accounting cost of share-based payments in a very basic 'snap shot' PE multiple valuation (and even then it could be very misleading, for example if you consider the implication of the profile of those charges over three years for ABDP). However, the accounted costs are entirely theoretical, do not represent the real cost to shareholders, and should be removed from any remotely sophisticated valuation methodology to be replaced by the true economic cost to shareholders, i.e. adjustments for the beneficial future cash in and detrimental additional shares issued.

ABDP recently placed 1.1m shares at 475p per share. This was not accounted as an expense charged to income; in fact it did not affect the income statement at all, it affected the balance sheet - cash went up and share capital went up. Economically, the valuation impact of the 1.3m share options at 395p will be exactly equivalent to the effects of the placing for shareholders. Think of it as a deferred placing at a deep discount.

Wimbledonsprinter

25th Aug '17

Sorry for being very late to this thread. I heard Tony Best speak at a few months ago at a presentation and his attitude to the share options stopped me from buying the shares. It seems a well run company but as a shareholder I want the company to only dilute me when it is clearly in my interests. Why are management and staff being given options? To remunerate / incentivise them to stay in the company, which may or may not be more efficient than doing it in cash - but to me it is clearly a cost and should be (and is) accounted as such in the statutory numbers. The "adjusted" numbers therefore, to my mind, give a false picture.

Flackwell

Not only do successful awards dilute existing shareholders - they are often sold on vesting (even if only to meet the tax bill) such that the SP is then affected.

And that's before the further question of whether profits are 'timed', 'manipulated' or otherwise 'massaged' to ensure maximum vesting

Salaries for me anytime

Share-based payment costs - ABDP case study

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Effortless Cool

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