With 57 percent of public companies offering their workers employee stock purchase plans (ESPPs), according to the National Association of Stock Plan Professionals (NASPP), understanding how qualifying dispositions work is an essential skill.

The concept refers to someone selling or otherwise “disposing” of equities who sees advantageous tax benefits. This is especially pronounced when a stockholder’s normal tax income rate differs markedly from prevailing tax rates for long-term investments.

Eligible individuals are those employed by a company that offers such a benefit. There are two different options available for worker participation.

The first option is where employees participate in the ESPP. The second option is through an incentive stock option plan (ISOs). It’s noteworthy to distinguish that the ESPP is for most employees employed after a particular time at a company. However, ISOs are reserved primarily for senior management and executives, such as chief financial officers (CFOs), chief executive officers (CEOs), etc.  

What determines if it’s a qualifying disposition is how long the employee keeps the equities prior to the sale.

ESPP Example

If 100 shares are acquired via ESPP, bought via a 10 percent discount to the prevailing offer of $40, the purchase of 100 shares of stock at $36 equals $3,600. If the stock appreciates to $60 in the future, the difference (and capital gain) would be $2,400 in profits ($6,000 – $3,600).

Qualifying Disposition Example

This scenario breaks down how the discount and, ultimately, how capital gains are treated.

The discount of $4 per share is taxed at the employee’s present wage rate. Depending on the tax rate the employee is taxed at, the liability would be ($4 a share, multiplied by 100, times the tax rate of 30 percent or $120).

Using the ESPP example’s figures, the long-term gain of $24 per share (times 100 shares) is taxed based on the lesser rate of say 15 percent. ($3.60/share times 100 = $360).

Therefore, the entire taxes owed end up being $120 + $360 = $480.

Non-Qualifying Disposition Example

However, for stock liquidations not meeting qualifying disposition criteria, the $2,400 would see a 35 percent capital gains tax ($2,400 multiplied by 35 percent = $840).

Based on the qualifying versus non-qualifying distribution scenarios, the difference of $360 in capital gains savings represents a stark contrast in tax obligations. Therefore, it’s important to determine how to meet a qualifying disposition.

It requires the following criteria to be met. The stock sale date must occur at a minimum of 12 months from the stock purchase date. It also must be held for at least 24 months from the ESPP offer date or the ISO stock warrant date.

While transactions may differ in the quantity of shares sold and for how much, the timing for workers selling the shares is far less variable. It is important for employers to ensure workers are familiar with the tax implications.

 

Sources

https://www.naspp.com/blog/five-trends-in-espps

Whether you are an investor, an owner, or an internal financial analyst, understanding how the equity multiplier works and how to interpret it is a helpful skill.

Defining the Equity Multiplier

The equity multiplier is a metric that tells the user what percentage of the company’s assets are loaned against shareholders’ equity. The smaller the calculated number for the equity multiplier, the less risky the financing is due to less debt owed by the company. It’s more favorable since there are lower debt servicing costs needed. When liabilities and/or assets change, the company’s equity multiplier changes.

Conversely, the bigger the equity multiplier, the more likely investors will be exposed to financial risk. This is due to the company having more outstanding debt, requiring more cash flows to service ongoing debt repayment, along with normal operations. A good rule of thumb is that anything lower than 2 is good, while anything higher than 2 signifies risk.

Putting It into Context

Since companies obtain financing through a mix of equity, debt, or both, it’s important to measure and monitor how the combination changes over time. Since investors look at the metric, among other financial yardsticks, it can influence how they determine if a company is worth investing in. Investors compare one company to others in the same industry and against historical measures to see how the company rates financially. The equity multiplier is measured relative to past measures, industry standards, or its sector competitors.

The ratio is calculated as follows:

Equity Multiplier = Total Assets / Total Shareholders’ Equity

Both input values are found on the company’s balance sheet, either on the quarterly or annual reports filed with the United States Securities and Exchange Commission.

If a company wants to go public, it can calculate this ratio to determine if its present results are robust for lenders’ review. Say a company has $2 million in total assets and $1.25 million in shareholders’ equity. Based on these numbers, it’s calculated as follows:

= $2,000,000 / $1,250,000 = 1.6  

The equity multiplier in this scenario, which shows a moderate amount of borrowing, may or may not pose an issue for the company’s financial health.

If a business’ total assets are $450 billion, and shareholders’ equity, according to the financial statements, was $150 billion, the company’s ratio is 3X ($450 / $150).

If a different company’s assets are $825 billion with $165 billion of shareholders’ equity, the same resulting ratio is 5X ($825 / $165).

These calculations show that as the ratio of liabilities and asset values adjusts, the equity multiplier also changes because a company uses less debt and more shareholders’ equity to finance the assets. While higher equity multipliers can help companies grow faster, especially during low interest rate and high-growth environments, if borrowing costs rise and/or sales fall dramatically, it can forecast negative growth. Investors favor businesses with low equity multipliers since this indicates the company is using more equity and less debt to finance the purchase of assets.

Regardless of the company or the industry, understanding how the ratio is calculated and used in making investment decisions makes sense for both companies and their potential investors.

An activity cost driver is anything that causes a company’s variable costs to either reduce or grow. Since measuring an activity cost driver is a way to streamline the administration of managing production costs, it’s an integral part of activity-based costing.

Examples of activity-cost drivers are warehouse expenses, modifying engineering designs, and retooling, setup, and maintenance costs for machining needs. This can include higher warehouse expenses due to increased rents or leases, which add to the final amount of the product or service’s sales price. Machining costs include initial setups for initial production and ongoing maintenance costs for continued runs. If production needs to be re-engineered to different production parameters, those professional revision costs need to be added to the ultimate product or service cost calculations.

These cost drivers are used as a starting point to project the business’ operational and profitability goals through the use of activity-based costing (ABC), a type of managerial accounting.

ABC accounting is a way to determine the expenses of each output by looking at the inputs used during the company’s operations, be it power for the machinery, Information Technology (IT) needs, or labor.

It’s important to know that one variable expense can impact multiple single activity cost drivers. For example, wage costs and machining expenses can be identified as activity cost drivers in connection with production. The first step is looking at how ABC accounting can determine indirect costs.

Activity-Based Costing Illustration

A business wants to look at how its production space and its lease or real estate and property tax costs are attributable to individual widgets or services, based on the percentage dedicated to the respective product or service. If it’s not allocated properly, determining sales prices and profitability can be negatively impacted.

If a company has two product lines with the same retail prices and production quotas, with direct costs of $700 and $250, it’s important to see how the production area for each product impacts the company’s overall operations. If the first item uses 40 percent of the production area and the second item uses 60 percent of the production area, and the rent is $1,500, the rent needs to be factored in. The first item would see an additional cost of $600 plus the original $700, or a total of $1,300. The second item’s cost would be $900 for the rent and $250 for the item, or a total of $1,150. While the initial direct cost for the first item seems higher than the second item, when factoring in all costs, this time it’s still true – but that’s not always the case.

Once this has been established, and then a company receives a new order, the following illustrates how measuring an activity cost driver, such as performing maintenance on machines after a production run, will cost the company to have it ready for their next order. If it costs a company $200 for machine maintenance and it produces 1,000 widgets, a $0.20/widget cost would be factored into margins and retail pricing.

While this provides an overview of how activity cost drivers work, it is part of a comprehensive approach to how businesses measure their margins and ultimately profitability. 

Whether it’s an individual investor or a business owner looking to increase their earning power, understanding how accretion works is essential for individual and business investors to make the correct decisions going forward.

How Accretion Works for Bonds

Accretion is the gradual increase of a bond’s value over time. As a bond moves toward its maturity date, it increases in value until it reaches its face or par value – or what’s paid to the bondholder upon maturity.

If a bond has a face value of $2,000, yet it’s discounted at $1,900 when it’s offered for sale, the present value of the bond is $1,900, leaving the difference of $100 as the discount. Between the time of purchase and when it matures, the value of the bond will appreciate, up to its par value of $2,000. As the bond increases in value, this is referred to as an accretion discount. 

When it comes to accounting for bond accretion, there are two common methods.

Straight-Line Method

This approach documents the bond’s appreciated monetary gain and is laid out equally over the bond’s time frame until maturity. For a bond with a term of 10 years and a business that publishes its earnings once a quarter, there are 40 earnings releases.

If there’s a $100 discount, spread across 40 quarters, that is $2.50 every three months. The $2.50 is the quarterly accretion until the bond matures.

Constant Yield Method

This method is different from the straight-line method in that the bond’s value appreciation increases in value closer to the bond’s maturity date.

Acquisitions and Accretion

Companies can also benefit from accretion. Through the concept of synergy, where there’s more output from combining multiple entities than the sum of them if still separate, an acquiring company adds the earnings before interest, taxes, depreciation, and amortization (EBITDA), for example, to add to its existing shareholders’ value.

Illustrating How it Works

If Company X wants to increase its earnings per share for its shareholders, an acquisition is one way to do so. Assume Company X earned $1 million in net income the preceding year and has 3 million shares. And then there is Company Z, which had $500,000 in net income over the same time frame, with 1 million shares issued to raise cash. The following is a way to calculate the acquisition accretion value of the new combined company.

Earnings Per Share of Company X: 1,000,000 / 3,000,000 = 0.33

Earnings Per Share of the new company post-acquisition: ($1,000,000 + $500,000) / (3,000,000 + 1,000,000) = $1,500,000 / 4,000,000 = 0.375

Based on the calculation, the earnings per share of the post-acquisition company are $0.375. Compared to the EPS for the original, pre-acquisition Company X, the post-acquisition company is $0.045, resulting in a positive acquisition accretion.

Whether an individual investor is looking to see how bond accretion works or a company is looking at whether an acquisition makes business sense, understanding how accretion works is essential to ensure it’s accounted for properly.

When it comes to evaluating a business, there are many ways to perform a valuation. One way to do so is to use the Q Ratio. Known as Tobin’s Q Ratio or simply the Q Ratio, this method looks at the proportion between the values of a physical asset and its replacement cost. Developed by Nobel laureate economist James Tobin, this ratio presumes a single company; for public investors, if asset values can be estimated, the company’s market value of a publicly traded company may be approximately estimated.

The original formula is as follows:

Q Ratio = Market Value of Assets / Replacement Cost of Capital

While this formula is the original iteration, approximating an asset’s replacement value is complicated and oftentimes not 100 percent realistic to analyze. The more realistic way it’s calculated is by using book values in lieu of the asset’s replacement costs. The new way to calculate it is as follows:

Q Ratio = (Equity Market Value + Liabilities’ Market Value) / (Equity Book Value + Liabilities’ Market Value)

When it comes to calculating the overall market’s Q Ratio:

Q Ratio = Value of the Stock Market / Corporate Net Worth

Putting the Q Ratio in Practice

Essentially, it’s used to value a company. Once calculated, the Q Ratio provides internal stakeholders and outside investors with one way to evaluate a company.

Above 1

If the Q Ratio is more than 1, the business’ market value is higher than its booked assets. It means a company’s valuation is overestimated in the eyes of the market since there is some portion of the company’s assets that are either not documented or valued fully. When the Q Ratio is above 1, a business’ earnings are worth more than replacement costs for the assets. At this level, entrepreneurs are incentivized to develop a competitor business to gain market share and financial gain.

Equal to 1

When the Q Ratio equals 1, it implies the market sees the company’s assets as valued fairly.

Below 1

At this level, a business’ assets are worth more than fair market value, establishing the business as undervalued. Investors with enough assets can purchase the company in question, either via shares if publicly traded or outright if a private company, versus trying to create a competitor company to siphon value away from it.

Further Consideration

When it comes to the calculated Q Ratio, it’s important to keep it in context. While accountants can be precise with many things during preparation, when it comes to market forces and intangible assets, analysts need to use their judgment. Investors and market forces can create hyperbole for a business’ value that can’t be quantified and recorded by accountants. Stock analysts’ perspectives on a business’ prospects or rumors regarding future performance can modulate the present, dynamic valuation of the company.

Another consideration is how to document and gauge intangible assets like intellectual property and goodwill. While accountants can approximate IP or goodwill, it’s not an exact science.

Thus, when businesses use the Q Ratio to value their own company or one they consider purchasing, investors must take the Q Ratio as part of a holistic valuation approach.