Quest Diagnostics 2006 Annual Report Download - page 77

123, as amended by SFAS 148. Under this approach, the cost of restricted stock awards was expensed over their
vesting period, while the imputed cost of stock option grants and discounts offered under the Company’s
Employee Stock Purchase Plan was disclosed, based on the vesting provisions of the individual grants, but not
charged to expense.
The process of estimating the fair value of stock-based compensation awards and recognizing stock-based
compensation cost over their requisite service period involves significant assumptions and judgments. We estimate
the fair value of stock option awards on the date of grant using a lattice-based option-valuation model which
requires management to make certain assumptions regarding: (i) the expected volatility in the market price of the
Company’s common stock; (ii) dividend yield; (iii) risk-free interest rates; and (iv) the period of time employees
are expected to hold the award prior to exercise (referred to as the expected holding period). The expected
volatility under the lattice-based option-valuation model is based on the current and historical implied volatilities
from traded options of our common stock. The dividend yield is based on the approved annual dividend rate in
effect and current market price of the underlying common stock at the time of grant. The risk-free interest rate is
based on the U.S. Treasury yield curve in effect at the time of grant for bonds with maturities ranging from one
month to seven years. The expected holding period of the awards granted is estimated using the historical
exercise behavior of employees. In addition, SFAS 123R requires us to estimate the expected impact of forfeited
awards and recognize stock-based compensation cost only for those awards expected to vest. We use historical
experience to estimate projected forfeitures. If actual forfeiture rates are materially different from our estimates,
stock-based compensation expense could be significantly different from what we have recorded in the current
period. We periodically review actual forfeiture experience and revise our estimates, as considered necessary. The
cumulative effect on current and prior periods of a change in the estimated forfeiture rate is recognized as
compensation cost in earnings in the period of the revision.
Finally, the terms of our performance share unit grants allow the recipients of such awards to earn a variable
number of shares based on the achievement of the performance goals specified in the awards. The actual amount
of any stock award is based on the Company’s earnings per share growth as measured in accordance with its
Amended and Restated Employee Long-Term Incentive Plan for the performance period compared to that of a
peer group of companies. Stock-based compensation expense associated with performance share units is
recognized based on management’s best estimates of the achievement of the performance goals specified in such
awards and the resulting number of shares that will be earned. If the actual number of performance share units
earned is different from our estimates, stock-based compensation could be significantly different from what we
have recorded in the current period. We periodically obtain and review publicly available financial information
for the members of the peer group and compare that to actual and estimated future performance of the Company,
including historical earnings per share growth as well as published estimates of projected earnings per share
growth. This information is used to evaluate our progress towards achieving the performance criteria and our
estimate of the number of performance share units expected to be earned at the end of the performance period.
The cumulative effect on current and prior periods of a change in the estimated number of performance share
units expected to be earned is recognized as compensation cost in earnings in the period of the revision. While
the assumptions used to calculate and account for stock-based compensation awards represent management’s best
estimates, these estimates involve inherent uncertainties and the application of management’s judgment. As a
result, if revisions are made to our assumptions and estimates, our stock-based compensation expense could vary
significantly form period to period. In addition, the number of awards made under our equity compensation plans,
changes in the design of those plans, the price of our shares and the performance of our Company can all cause
stock-based compensation expense to vary from period to period.
In the fourth quarter of 2006, the Company revised its estimate of the number of performance share units
expected to be earned at the end of the performance periods as a result of revising its estimates of projected
performance and reduced stock-based compensation expense associated with performance share units by
approximately $8 million. Refer to Notes 2 and 12 to the Consolidated Financial Statements for a further
discussion of stock-based compensation.
Results of Operations
Our clinical laboratory testing business currently represents our one reportable business segment. The clinical
laboratory testing business for the years ended December 31, 2006, 2005 and 2004 accounted for approximately
92%, 96% and 97% of net revenues from continuing operations, respectively. Our other operating segments
consist of our risk assessment services business, our clinical trials testing business, our healthcare information
technology business, MedPlus, and our diagnostic products business. On April 19, 2006, we decided to
discontinue the operations of a test kit manufacturing subsidiary, NID. During the third quarter of 2006, we
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