We will explain the most important part of spreading comps for investment bankers in this post.
The brunt of conducting comparable companies analysis is to calculate the appropriate enterprise value, which will have certain components which are “live” and certain components that are the latest historical financial statement data. So to understand comps, bankers must have a very good understanding of enterprise value.
From there, the enterprise value and market capitalization will just flow to all of the relevant metrics such as EV/EBITDA and Price/Earnings.
This is because no one actually knows what 2020, 2021 and 2022 EBITDA and net income are going to be, so usually banks will just use the latest broker consensus number that can be easily swiped from Bloomberg or Reuters. Broker consensus means the average of equity research analysts that cover the stock.
Calculating Fully Diluted Market Capitalization
Basic Market Capitalization
The first step is to get the most recent share count or number of shares outstanding. This will be found on the first page of the latest 10Q or 10K.
Some groups prefer to get the share count as of the reporting date (for example, March 31, 2019 if the latest financials are for 1Q2019), but at least in theory, the share price and value of the company should reflect all available information. So unless instructed to otherwise, use the latest share count.
There will also usually be a schedule that breaks down how the share count got to where it is from the previous quarter (beginning balance minus share repurchases plus share issuances and vesting of stock options and units).
The current share price is available on Bloomberg, Factset, CapitalIQ or Reuters.
Multiply this basic share count and the current share price and the result is basic market capitalization.
Accounting for Dilutive Instruments (and Anti-Dilutives)
However, this is not the figure that investment bankers or investment analysts want. There are a number of financial instruments that could dilute existing shareholders by adding to the share count and they have to be addressed.
The most common dilutive instruments are a function of stock based compensation for employees, executives/management and the Board of Directors. These are stock options and stock units.
When payment is physical or equity-settled (payment is granted in the form of additional shares issued from the company’s treasury), this is dilutive to shareholders. When it is settled in cash, this is not dilutive to shareholders (as no new shares are added to the total).
Stock Options – Traditional Method and Treasury Stock Method
Stock options are usually physically settled – and as they are options with an associated strike price, the company actually receives money when the options are exercised. A stock option is basically compensating employees with a call option on the company at varying strike prices to incentivise them to try their hardest to help the company succeed.
So for example, if Blackrock is trading at $433 per share and an employee has 1,000 options with a strike of $403, this means that they can exercise their options and receive 1,000 shares for $403,000. They can immediately sell these shares for a $30 profit each and cash out $30,000. Blackrock will issue 1,000 new shares from its treasury but now has $403,000 in additional cash.
Stock option information can be found in the share or stock based compensation section under notes to the financial statements.
Now for the purposes of calculating fully diluted market capitalization, there are two primary methods – 1) the traditional method and 2) the treasury stock method.
The traditional method is easy – the number of stock options outstanding that are in the money is simply added on to the basic share count. This increases the fully diluted shares outstanding, which increases market capitalization. However, the company will receive cash for the exercise for these options, so the resultant higher cash will reduce enterprise value.
The treasury stock method is used to calculate fully diluted earnings per share and other per share metrics.
To calculate additional shares, the assumption here is that all of the cash that the company receives is immediately used to repurchase shares at the same price in the open market.
Additional Shares = # of in-the-money stock options – (cash received from exercise of options/share price)
Cash received from options is the strike price multiplied by the options.
Usually, the year end financials will show the full schedule of options with various weighted average strike prices. The quarterly financials may have a simplified version.
Ultimately, both of these methods will get an analyst to the same place in terms of enterprise value – the difference being that the traditional method results in a positive adjustment to cash later while treasury stock method provides a net figure.
Stock options that are out of the money (the current share price is below the strike price) are not counted and are considered anti-dilutive instruments.
Stock Units and Dilution
Stock units such as performance stock units (PSUs), restricted stock units (RSUs) and deferred stock units (DSUs) are often cash settled. Most stock units do not have associated strike prices, so any units that are physically settled should be added directly to the share count for a fully diluted calculation. However, there are times when stock units have strike prices as well.
If the stock does very well and it is cash settled, this can be expensive for the company, but can be hedged with equity derivatives such as call options or total return swaps.
Convertible Instruments and Dilution
Financial instruments with mandatory convertible features (they will convert to common shares no matter what after a certain time) should be accounted for as dilutives depending on their conversion ratio.
However, most of the time analysts are dealing with optional conversion features – standard convertible bonds and prefs. These convertible bonds and preferred shares will allow the holder or owner to convert the bonds or prefs into a set number of shares (the conversion ratio). The face value of the convertible divided by the conversion ratio is basically a strike price.
In the meantime, the bonds and prefs will pay coupons and preferred dividends like normal bonds and prefs.
For the purposes of calculating fully diluted market cap, if the instruments are in-the-money, they are added to the fully diluted share count.
If they are anti-dilutive, they are just treated as normal bonds and preferred shares. Deeply out-of-the-money convertible bonds and prefs are known as busted convertibles and trade as straight bonds or prefs in the market.
Analysts have to exclude them from debt or preferred equity if they are dilutive to avoid double counting.