This document analyzes Microsoft's shareholder equity between 1994-2000 when the company grew rapidly. It discusses several key points: 1. Microsoft's revenue grew 700% and earnings grew 1200% during this period, with its stock price peaking between $36-120 per share. 2. Microsoft used stock options extensively to attract talent, but GAAP accounting did not report this significant cost as an expense or liability. 3. Various issues are analyzed including cash paid to shareholders, comprehensive income calculation, dilution from stock options, and proper valuation of shares given stock option treatment. 4. The quality of Microsoft's reported income and share valuations during this period are questionable given the underreporting of significant

1. Financial Statement Analysis & Valuation
Chapter 8 – Microsoft Case
Analysis of Shareholder Equity

2. BACKGROUND
 ‘Most successful Software firm ever’
 Between 1994 and 2000,
 Revenue grew by more than 700%
 Earnings grew by more than 1200%
 Peak of Dotcom Bubble (Between 1998 and 2000):
 Stock price rose from $36 to $120 per share
 Trailing P/E ratio went as high as 66
 Has significant ‘Knowledge Capital’
 Stock Options used to attract leading talent
 GAAP Accounting does not report this cost nor even significant
off-balance sheet liabilities to pay for the knowledge

3. QUESTIONS TO TACKLE
 Cash paid to shareholders
 Comprehensive Income
 Issues with Comprehensive Income
 GAAP Reporting & Put Options
 Reversal of Dilution
 Loss to shareholders from employees
 Correct treatment of tax benefit accounting
 Quality of reported income
 Issues in valuing shares due to stock options
treatment

4. 1. CASH PAID TO SHAREHOLDERS
Cash Transactions with Shareholders (Amount in Millions)
Common Stock Issued $ 1750
Common Stock Repurchased ($4872)
Net Cash Paid to Shareholders $ 3122
Working Backwards:
Cash Transactions with Shareholders (Amount in Millions)
($
$980 given in
Common Stock Repurchased ($ 186.00) 4872)
case, $113
difference ($ 4686)
Common Stock Issued $ 2843.00
Preferred Stock converted to common stock $ 1093
Net proceeds on issue of common stock $ 1750
Net Cash Paid to Shareholders $ 3122

5. 2. COMPREHENSIVE INCOME
Comprehensive Income
Net Income $ 7012.00
Other Comprehensive Income
Net unrealized investment gains $ 2724.00
Translation adjustments and other $ 166.00
Preferred dividends $ (13.00)
$ 9889.00

6. 2. REFORMULATED STATEMENT
Beginning Equity $ 27,458.00
Transactions with Shareholders
Common stock issued $ 2843.00
Proceeds from sale of put warrants $ 472.00
Tax benefit from stock option exercise $ 4002.00
Common stock repurchased $ (4872.00)
$ 2445.00
Comprehensive Income
Net Income $ 7012.00
Other Comprehensive Income
Net unrealized investment gains $ 2724.00
Translation adjustments and other $ 166.00
Preferred dividends $ (13.00)
$ 9889.00
Ending Equity $ 39,792.00

7. 3. COMPREHENSIVE INCOME - ISSUES
Comprehensive Income should include Gains or Losses on changes in the value
of put warrants and stock based compensation expense net of tax benefits.
 Stock Option loss : Tax benefit = $ 4.002 bn
 Stock based compensation expense and related tax benefit
would affect the operating income
 Option overhang of After tax Stock Option Loss is an off-
balance sheet item
 Preferred Stock converted to Common Stock
 Conversion @ $77 per share whereas market price of $93
 Loss on conversion to common stock is recognized in
income statement
 Sale of put warrants – Stock options are contingent liabilities
 Premium should be recognized as liability
 Change in valuation of liability (or warrant ) is recorded as
loss (gain) in income statement

8. 4. EXERCISE OF PUT OPTIONS
 GAAP Reporting
 Stock Repurchase @ Exercise Price
 Loss on put options is not recognized on balance sheet
 Clean-Surplus Reporting
 Write off corresponding financial obligations
 Common Stock Repurchased at market price
 Recognize loss in Income Statement (Retained Earnings)

9. 5. REVERSAL OF DILUTION?
 Can repurchase of shares reverse dilution
arising because of stock option being
exercised?
 No.
 Ifrepurchase is at fair value, there is no change
in per share value of equity. The share holder
doesn’t get extra value to compensate for the
loss of value from stock options.
Only the number of outstanding shares remains unaffect

10. 5. REVERSAL OF DILUTION?
 Are repurchases at share prices of 2000
level, advisable?
 No.
 Duringtech bubble, employees exercised stock
options at high prices
 Firms had to buy back shares at high prices
further increasing the dilution
Double hit for remaining shareholders

11. 6. LOSS TO SHAREHOLDERS
 Tax benefit = $ 4.002 billion
 Stock Option Loss = $ 4.002/ 0.375 = $ 10.672 billion
USD Billion
Stock Option Loss 10.672
Tax Benefit @ 37.5% 4.002
Stock Option Loss After-tax 6.67
Compensation cost net of tax would be recorded on the income statement
over the period between the option grant date and the date the options becom
exercisable

12. TAX BENEFIT AS CFO
 Ideally, Stock based compensation and corresponding
tax benefit should be recognized as cash flow from
operations
 GAAP doesn’t recognize Stock based compensation as
an expense
 And recognizes tax benefit as financing activity
 EITF requires tax benefit to be recognized as CFO

13. 7. TAX BENEFIT– CORRECT TREATMENT
USD Billion
Tax Payable 3.612
Tax benefit 4.002
 Tax ( to be paid ) comes to be negative by this calculation
 Microsoft should have recognized the compensation expense in Income
statement along with Tax benefit
USD Billion
Income Reported, before Tax 10.624
Loss on exercise of SOP 10.672
Loss before Tax (.048)
Taxes (3.612 – 4.002) (0.390)
Net Income 0.342

14. 8. QUALITY OF REPORTED INCOME
 MS pays low tax on a high income
 It is recognizing expenses for tax benefit
 But the same expense is not carried on its books
Quality of earnings is not reliable.
Other revenues and expenses might not be accurate either

15. 9. ISSUES ARISING IN VALUING SHARES
 Share repurchases
 Is this at fair value or higher prices?
 Put warrant liability
 The options are currently out of money
 But the exercise date for some was till Dec 2002, and
subsequently share price fell drastically.
 No liability recorded as put warrants went into money
 Nor any loss on these warrants would be recognized when
exercised
 Valuation of shares should be adjusted accordingly for off-
balance sheet liability

16. 9. VALUATION OF SHARES
 MS valuation
 Preferred Stock Conversion
USD
Net proceeds from issue of convertible preferred $ 1093 million
stock
Number of convertible preferred stock issued 12.5 million
Price per stock ( preferred ) $ 87.4
Conversion Ratio 1.1273 (common
stock )
Price per common stock $ 77
Price Share on Dec 15, 1999
/ Book value of preferred $ 93
stock was converted to book
value of common stock issued and no loss was
recorded

17. 10. KNOWLEDGE LIABILITY
Outstanding Wtd. Avg. Remaining Black Overhan
Options (mm) exercise Life Scholes g ($
price ($) Option Value mm)
133 4.57 2.1 75.972 10,104
104 10.89 3 70.908 7,374
135 14.99 3.7 68.009 9,181
96 32.08 4.5 56.079 5,384
198 63.19 7.3 45.495 9,008
166 89.91 8.6 40.781 6,770
832 47,821
Note: Additional values required for Black Scholes calculation as on June 30,
2000:
stock price=$80; risk free interest rate=6.2% ; volatility=33%

18. MICROSOFT IN RECENT YEARS
Current Stock Price: $26.63 Mkt Cap: $224.5 bn
EPS 2000 = 1.35 P/E 1998-2000 = 66
EPS 2011 = 2.52 P/E 1998-2000 = 10.62 P/E Industry =
18.30

19. QUESTIONS?