Interview Question: EV/EBITDA and in-the-money stock options impact
Hi,
Does anyone have any insight on what happens to EV/EBITDA with an in-the-money stock option exercised?
My logic: EV = Equity Value + Minority Interest + Preferred - Cash
In-the-money stock option typically dilutes equity value. Hence, EV is smaller. If EV is smaller in the numerator of EV/EBITDA, the ratio will decrease.
However, if we think about stock-based compensation. This is also included in EBITDA. Hence, if this is the case and is related, it could have no effect, or opposite effect from the reasoning I just mentioned?
Thank you
IMO It raises equity value but also cash, excluding fees your EV should be unchanged and so the multiple
EV/EBITDA should expand - equity value should increase by more than cash since the market value of the new equity will exceed the cash raised (you sold them at the strike price which should be than market value)
Nothing happens. Trick question. Exercised options lower value per share of equity but not total value of equity. Thus EV is unchanged. The expense is below the line so no impact to EBITDA.
Could you expand on what you mean as below the line? Where does the expense your referencing fall on the income statement which does not effect EBITDA figure?
Stock comp expense would be reduced as options are exercised. This doesn't impact EBITDA (typically added back to EBIT with DA to get EBITDA as it constitutes a non cash expense).
Apologies for continuing to probe on this. Trying to get it.
How do options lower per share of equity but not total value of equity? If equity value is diluted as per options recognized, shouldn't the EV change?
Also, if stock comp expense decreases, that means you add a smaller number back (DA) to EBIT, hence smaller EBITDA?
Many thanks
Your equity value is a function of free cash flow to equity. This isn't impacted by diluted share count. Your price per share will be, but not your total equity value. As a general rule, financing activity will only impact enterprise value if there are tax benefits and/or potential restructuring/bankruptcy costs. This is not always the case but it's a useful rule of thumb (there are circumstances where financing decisions impact principal-agent relations and may lead to managerial inefficiencies). I could mathematically prove it but not in the mood honestly.
100 (Rev) - 20 (expenses) = 80 EBIT + 10 (Stock Comp) = 90 EBITDA
100 (Rev) - 15 (expenses) = 85 EBIT + 5 (Stock Comp) = 90 EBITDA
EBITDA is unchanged.
In practice I've seen more often than not, SBC not being added back to EBITDA despite it technically being a non-cash expense, both on the buyside and sellside for valuation purposes. Options are a way to align incentives or defer cash outflow for early stage cash strapped companies that will eventually have to pay market compensation, but not meant to 'manipulate' valuation by just issuing more SBC rather than cash comp and increasing EV by allowing it to be added back. Debt covenant definition often allows you to add it back though.
Regarding OP's original question, EV doesn't change when existing ITM options are exercised. 1) EBITDA already included the historical expense of those options that are not exercising, and 2) all else equal, nothing about the company's ability to generate future CF changes with existing options exercising (e.g., unless it was some key management team exercising his/her options in order to get liquidity and leave the business, nothing should change).
It is clear that EV does not change but what about equity value? Does exercising option increase equity value?
Thank you everyone for your responses and continued support.
I am struggling to understand this concept here (a bit related to the original question):
Let's say a company issues $100mm in equity what are the effects on EV and Equity Value?
EV = no change, no change since equity increases equity value and cash obtained decreases EV by same amount
But with this logic, how come market cap = equity value does not change when looking at it separately from EV.
For instance - equity value = market cap = number of shares * share price
If equity is issued, number of shares increases, and share price dilutes due to the number of extra shares issued and hence total equity value remains the same as in the above discussion.
That said, what am I missing here? In the EV we said EV remains constant since equity value goes up, but in market cap calculation we said it stays the same.
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