ESOs: Dilution - Part 1
  1. ESOs: Introduction
  2. ESOs: Accounting For Employee Stock Options
  3. ESOs: Using the Black-Scholes Model
  4. ESOs: Using the Binomial Model
  5. ESOs: Dilution - Part 1
  6. ESOs: Dilution - Part 2
  7. ESOs: Conclusion

ESOs: Dilution - Part 1

By David Harper (Contact)

Investors clearly care about the cost of employee stock options (ESOs), but they do not yet agree on the single best method for capturing the ESOs' economic cost. In the preceding sections of this feature, we focus on the accounting treatment and valuation of employee stock options. In this section and the final one of this feature, we review ways to assess the economic impact of ESOs.

We will review four methods used to assess the economic impact of ESOs in order of their increasing accuracy and complexity. Here, we review diluted EPS, equity overhang and economic overhang. In the final section of this feature, we will show how to apply the cash-flow method, which is the most accurate but also the most complicated. For all methods, we will use actual data from Motorola's 2003 Annual Report (Form 10K, Ticker: MOT).

Pro Forma Diluted EPS
The easiest approach is to check a company's pro forma diluted earnings per share (EPS). Here are selected lines from Motorola's income statement for the year that ended December 31, 2003:

On Motorola's income statement, diluted EPS equals basic EPS. These are both reported EPS numbers - that is, they appear in the body of the income statement. But, because these numbers are rounded, it only appears as though they are equal: diluted EPS is actually half a penny lower (net earnings of $893/diluted shares of 2,351.2 = $0.3798 whereas basic EPS is $0.3846). Nevertheless, Motorola illustrates the problem of relying solely on diluted EPS: in Motorola's case, it implies that stock options create no dilution.

The reported diluted EPS shown above captures only the cost of outstanding options granted in previous years. In order to include the cost of options granted in the current year, we need to look at pro forma diluted EPS, which is shown in a footnote.

Here is footnote No.1 to Motorola's income statement:

In Motorola's case, the fair value expense of options granted during 2003 was $222 million, which reduced reported net earnings of $893 to pro forma net earnings of $671 million. Pro forma diluted EPS should incorporate all options: the 'pro forma' component captures the current options grants and the 'diluted' component captures the outstanding (historical) grants.

However, as the first part of this feature shows, diluted EPS only captures the impact of in-the-money options. And for these, it credits their intrinsic value, but not their time value. At-the-money and out-of-the-money options are entirely excluded, as they have no intrinsic value.

In footnote No.6, Motorola summarizes information about all outstanding options:

Because Motorola's average share price during 2003 was about $11.77, most of the outstanding options were not included in diluted EPS (about 194 million out of about 306 million). However, many of these are only a few dollars out-of-the-money (about 138.6 million out of about 194 million have a weighted average exercise price of $16).

The easiest way to assess options dilution is to complement pro forma diluted EPS with a careful look at outstanding out-of-the-money options, since they are left out of the calculation. In Motorola's case, we can take the pro forma diluted EPS of $0.29 and further consider outstanding options to account for an additional 8% of the share base (194 million out-of-the-money options/2.351 billion diluted shares).

"Simple" Equity Overhang
A popular way to gauge ESO cost is to measure equity overhang. Equity overhang adds the number of outstanding options, which are those that are already issued, to the number of options available for future grant, which are those that are yet to be issued. Overhang is also called potential dilution. The rationale for including "options available for future grant" is that we can almost always expect them to be issued in the near future.

Normally we would find the "number of options available for future grant" in the 10K footnote that reports options information (footnote No.6 for MOT). Motorola instead reports this number in their proxy statement, where we see they have 136.9 million shares available for future grant. So we have the following information:

We see that Motorola's basic equity overhang, as of Dec 31, 2003, was 19.1%. This popular measure is really a sort of worst-case dilution scenario: it says that if all of Motorola's options were exercised - including options already issued and those to be issued in the future - then the common share base would increase by about 19%.

Notice we also calculated overhang on a fully diluted basis, where the numerator is added to the denominator. The fully-diluted overhang implies that, after the hypothetical conversion of all options, new shares created (and owned by employees) would represent about 16% of the new common share base. Measuring overhang as fully diluted is technically the preferred way of measuring overhang; although, basic overhang is still used by some.

Economic Overhang
Some institutional shareholders look carefully at equity overhang, but not exactly in the way described above. In calculating Motorola's "simple" equity overhang, we determined that the dilution potential of their options is 16%. However, the problem is that all of Motorola's options are counted equivalently. Many of Motorola's options are out-of-the-money, and they are worth less than at-the-money-options. Some are far out-of-the-money and therefore are barely dilutive.

We can address this problem by estimating economic overhang. Economic overhang is very close to simple overhang: it uses fair values instead of numbers of options. So, consider Motorola's outstanding options.

Below we take the same footnote information and, using an options-pricing model, convert options quantities to fair-value estimates in the right-most column:

Motorola reports several categories of outstanding options, each of which we converted to a fair-value estimate. In total, the 305 million options outstanding are worth a little more than $1.8 billion.

The only thing we need to do is add the value of options available for future grant. (This is also disclosed in the same footnote, usually with the title "number of securities remaining for future issuance under equity compensation plans".) We assume these will be issued at-the-money:

Economic overhang divides the fair-value estimate of all of Motorola's options (about $2.7 billion) into Motorola's market capitalization (which is about $32.5 billion, but we also include the same fair-value estimate of $2.7 billion in order to get a fully diluted market capitalization). The result is 7.7%. In other words, we estimate that if all the outstanding and available options were converted, they would own 7.7% of the equity.

Motorola has a huge number of outstanding, out-of-the-money ESOs. Diluted EPS does not recognize these and therefore significantly understates the cost of Motorola's options. Equity overhang does include all of the outstanding options, but treats them all the same, and therefore, in Motorola's case, it overstates their dilutive impact or cost. Economic overhang uses a fair-value estimate instead of options quantities, and gives us an improved estimate of dilution.
ESOs: Dilution - Part 2

  1. ESOs: Introduction
  2. ESOs: Accounting For Employee Stock Options
  3. ESOs: Using the Black-Scholes Model
  4. ESOs: Using the Binomial Model
  5. ESOs: Dilution - Part 1
  6. ESOs: Dilution - Part 2
  7. ESOs: Conclusion
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