Hedge Fund Analyst Quiz

You just joined as a new analyst and your boss slaps this on your desk Adobe 2000 10K.   What is the real net income to shareholders? Assume a 35% tax bracket.

You remember from reading in Berkshire Hathaway’s 1992 annual report, “If 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 should they go?”

FAJ Stock Options and the Lying Liars Who Dont Want to Expense Them  No need to read this to answer the question.   detective



An answer will be posted next week.    The correct answer will garner a prize and adulation.

16 responses to “Hedge Fund Analyst Quiz

  1. Hi John,

    I’m going to take my best stab at this, as I’m not a professional financial analyst, but a hobbyist. Would love help on improving my process, so I’ll reveal how I arrived at my final answer.

    The 10k says net income is $287MM, pro forma $196MM – meaning without the abnormal revenue. Clearly this wouldn’t be a quiz if it was one of these two, so my guess is it’s something even lower than this, so now I go to the definition of NI = Revenue – expenses. Okay so what are those?

    $1.3B revenue, $770MM expenses, and thus $443M of net income. If you factor in taxes which they calculate as $156MM, you’ve got the $287MM NI we see above, so the math seems to check out.

    The hint you show is about the 35% tax bracket, which indeed comes out to $156MM in money lost to taxes. So that doesn’t get me anywhere. There’s another hint about options and compensation, so I started searching the 10k for those terms.

    Lots of interesting things happened in March 2000 wrt compensation of exercising options…they showed 3 years of compensation expenses of $215K in 97, then $2.7M in 98, and $10M in 99. So that’s a steep increase, culminating to $16.5M in 2000. Total accrued expenses of $182MM that don’t seem to be accounted for in the general total revenue, which seems to be a lot, with total liabilities upwards of $315MM.

    The only peculiar thing I noticed wrt to options was that they “reserved 2.5 million shares of common stock for issuance under our 1996 Outside Directors Stock Option Plan, which provides for the granting of nonqualified stock options to nonemployee directors.” That’s a LOT of shares to report, and the difference is staggering:

    ” In fiscal 2000, we granted options for 160,000 shares with an exercise price of $61.72 to existing directors and an option for 60,000 shares to a new director with an exercise price of $78.88. In fiscal 1999, we granted options for 80,000 shares with an exercise price of $14.86 to existing directors” And yet, the stock price of ADBE at the time of 2000 never peaked above $41…so a good deal of it could not possibly be exercised…to the tune of 20MM shares (256M shares outstanding as of Dec 2000, so basically 10% of the entire pool). Another odd thing was this: “1.8 million call options were outstanding that expire on various dates through July 2001 and have exercise prices ranging from $63.60 to $73.00 per share, with an average exercise price of $67.51 per share” – that seems exceptionally high given the year 2000 performance. So 1.8MM options with an exercise price of $67.51/share is apparently $121MM, not sure if this is a hint towards a lower price?

    Effectively my intuition is that the net income is high because they have inflated their stock options to absurdly high amounts, amounts they had never achieved in the history of the company up until that point. So removing the absurdly high options from the pro forma NI would leave us at only $166MM, which is the best I can do without another hint.

    What should I be looking at that I’m missing?

  2. I will wait until more people struggle with this. First focus on the concept–options are an expense. What is the company (you the owners) paying the employees? We want to figure out from the figures on the income statement and cash flow statement then adjust using the .35 tax rate rather than just noting the increase in shares (dilution). We are trying to get at the “real” expense. No wonder tech companies loved options.

    Remember that some of the best investors in the world like mike burry, Francis Chou, etc. were never Wall Street analysts. Teach thyself by reading, reading, reading.

  3. As stated (in ,000s):
    Rev $1,266,378
    Direct Cost $87,255

    Gross $1,179,123
    OpEx $771,040

    OpInc. $408,083
    Total non-op inc. $35,656

    EBT $443,739
    Tax Prov. $155,931
    @% 35.14%

    Net Income $287,808

    As mentioned:
    Options Outstanding 11,478,693
    Wtd. Avg. fair value $29.89

    As it should be (in ,000s):
    Rev $1,266,378
    Direct Cost $430,353

    Gross $836,025
    OpEx $771,040

    OpInc. $64,985
    Total non-op inc. $35,656

    EBT $100,641
    Tax Prov. $35,224
    @% 35.00%

    Real Net Income $65,417

  4. Not that it would make a difference in the real net income above, but I should’ve attributed the options compensation to OpEx rather than direct cost, for consistency. Real net income, still the same.

  5. So, looking at just net income per share (diluted – $1.13) is not enough?

    • No. EPS can be the most manipulated number on earth. I am not saying in this case but you must adjust to the economic reality.

      Amazon shows little profit, trading at 500 times earnings let’s say, but they are investing a lot that is immediately expensed but will have long-term effects to build their economies of scale. You should add back those expenses to gain a better understanding. .

  6. investtraderead

    Giving it a shot here. Not good at accounting but i see no harm trying.
    Based on 2000 statements, the tax benefit from stock option plan is 124.922m and assuming 35% tax, this will imply that options granted amounted to 356.92m. Subtracting this amount from income before tax, we get 86.819m before tax. After tax real income will be 56.43m

  7. taking a stab at building on the previous responses..

    Looking at the CF statement and AOCI they received a 124,922 tax benefit from their employee stock option plans. Would a simple calc just be 124,922/35% = 356,920 as the employee stock option expenses and net of taxes that would be 231,998 deducted from the net income.

    On note 10 Employee stock options they give a weighted average fair value of options granted for 2000 at $29.89 and ~20mm were granted that year with 11,478,693 exercisable at end of year. That would imply a cost of 587.9mm but some were canceled (4,076,433) and some were exercised (8,724,580 at 11.17 giving 97.45mm to the company) I am not quite sure what the fair value of those canceled options would be..

    So in addition to the PF net income of 196mm we’d be adjusting for these options and end up with a negative net income?

    • I am traveling so I will need to revisit this in a few days. But you ignore cancelled options since there is no expense to the company nor benefit to the employee.

  8. John, just wanted to give you a shout for putting together a fantastic blog/list of resources. As someone trying to learn value investing on my own, I can’t tell you how helpful this is.


  9. I think I figured it out John!

    Page 52 shows a peculiar line item regarding a “Tax benefit from employee stock option plans” to the tune of $125MM. But the thing is it’s an OPTION to buy a stock, the purchase may not have exactly gone through. It’s so hard to really track down exactly what this counts as – non-cash? Cash? Operating expense? In other words, it helps them inflate their net income with a bogus tax benefit. Aswath Damodaran covered this before:


    So now your income before taxes removes the $125MM in stock compensation and the $16.5MM in stock expense leaves us with $304MM, applying the 35% tax rate brings down the net income to $198MM.

    Sound about right?

  10. You are on the right track.

    Nonqualified stock options are the difference between the price of the stock and the price of the options when exercised and which accrues to the employee as income that must be taxed because it is considered compensation. Not according to GAAP but according to the IRS. So the IRS gives companies a break and allows them, for tax purposes, to deduct this options expense that employees receive as income. The net result is an income-tax benefit to the company of roughly 35% of the sum total difference between the exercise price of the company’s nonqualified options during a given year and the market price of the stock at the time of exercise.

    And since GAAP does not recognize this in the income statement, the cash flow statement records this “net income tax benefit from employee stock compensation” in operating cash flow as a positive adjustment to net income. The company included neither the cost of the options nor the income tax benefit on the income statement. Hence the correction to cash flow.

    When evaluating U.S. companies, investors ought to assume that if the IRS can tax something, then it is a real profit. And if they allow one to deduct something, then it is a real cost.

    For many tech companies, the net income tax benefit can be quite large in a rising market–but it only reflects 35% of the actual cost of paying employees with options. How does it cost the company? Because the company must either issue new stock or buy back stock for issuance to the employees in order for the employees to obtain this stock at a discount. The cost is born by the shareholders. The per share numbers worsen with the dilution while the absolute numbers improve since issuing stock at any price is a positive event for cash flow if not for shareholders.

    Look at the 10-K on page 52 on the cash flow statement, we see $124,922,000 or 125 million in income tax benefit for options which supplied 28% of operating cash flow. On page 49 on the income statement we see operating income of $408.1 million.

    We then take the 35% tax rate that Adobe pays and divide it into the tax benefit of $125 million to see the $357 million in employee compensation that the IRS says Adobe paid, but that does not appear on the income statment.

    We deduct the “employee compensation paid in options ($357 or $125/0.35 tax rate) from the $408 in operating income to get $51 million. Tax that at 35% and now you have about $33 million in net income or divide by 238.3 million outstanding shares to obtain 14 cents per share ( a far cry from the $1.13 in EPS reported by Adobe).

    The $33 million is the amount of net income that public shatreholders get after the company’s management and employees feed at the trough. For this $33 million buyers are paying $8.7 billion at the time in April 2000.

    Now the options expense may not be recurring because it depends upon when and if the employees elect to convert their options to shares and then sell, but the cost to shareholders is considerable.

  11. Hi John,
    Thanks so much for the discussion. I was wondering, haven’t GAAP accounting rules changed since 2000 to reflect the full cost of share-based compensation? For example, in the lates 10-K of Facebook, it records income tax benefit from issuance of share based compensation of 1.7 billion, but also records a share-basec compensation expense of $2.9 billion. This is still confusing to me, because using a $1.7 billion figure and a 40% tax rate, we ought to get $4.25 billion in share based comp, not $2.9.
    I’m wondering if you could shed some light into what the new entity (share based compensation expense) actually reports.

  12. Those who read Mike Burry’s Scion Capital letter from Q1 2001 should find this familiar:

    Looking at its annual report for 2000, one sees that the income tax benefit for options supplied $125 million, or roughly 28% of operating cash flow. Fair enough. Let’s move to the income statement. Divide that $125 million by a corporate tax rate of around 35%, and one gets an amount of $357 million. That’s the amount of employee compensation that the IRS recognizes Adobe paid in the form of options, but that does not appear on the income
    Plugging it into the income statement as an expense drops the operating income – less investment gains and interest – from $408 million to $51 million. Tax that and you get net income somewhere around $33 million
    – and an abnormally small tax payment to the IRS.
    That $33 million is a good proxy for the amount of net income that public shareholders get after the company’s senior management and employees feed at the trough. For this $33 million – roughly 1/10 of the reported earnings –
    shareholders were paying $8.7 billion around the time of this writing.

    • Correct. I couldn’t put the source or else people wouldn’t try on their own to figure the question out. Thanks!

  13. OK, Let me take a look, but I am traveling so I may be back after the holidays.

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