
By David Harper
In the last chapter, we looked at three ways to estimate the economic cost of employee stock options (ESOs). Each of these methods has certain disadvantages, but they can be calculated with relative ease. In this chapter, we review the most accurate way to calculate the true cost of stock options: the cashflow method. But keep in mind, this method also involves the most assumptions.
Cash Flow Cost of ESOs
From a cashflow perspective, stock options are not as dilutive as they might appear. Because the employee pays a tax on his or her options gain (in the case of nonqualified options, which are the vast majority), the company gets a tax deduction, which is a cash savings. Consider a regular stock option issued at $10 before the stock jumps to $15. The company gets the $10 in exercise proceeds plus a tax savings. If the company's tax rate is 40%, you can see below how the cashflow cost of this option is only $3 on a net basis:
Stock Issued at $15  $15 
Exercise Proceeds Received  +$10 
Tax Benefit, 40% of $5 gain  +$2 
Cash Outflow  $3 
Three steps are required to estimate the cashflow cost of ESOs:
 Estimate the aftertax cash cost of outstanding (already issued) ESOs.
 Estimate the discounted aftertax cashflow cost of future ESO grants.
 Combine outstanding and future ESO grants; then reduce the "undiluted" share value accordingly.
For this and the chapter before this one, we use actual data from Motorola's (ticker: MOT) 2003 Aannual Report. Like all companies, Motorola must report its outstanding stock options. These are listed at various "exercise price ranges". Assuming a MOT stock price of $14, we can see that most of these outstanding options are out of the money. On the lefthand side of the exhibit below, we show the footnote data as seen in the annual report:
On the righthand side, we used an optionspricing model to estimate the pretax value of these options. By doing so, we capture both an intrinsic value (for the few options that are in the money) and an estimate of time value. Each pretax value is converted to an aftertax value, assuming a tax rate of 40%.
So, for example, in the first row we see that Motorola has 578,000 options outstanding at an average exercise price of $4. Given a stock price of $14, our optionspricing model estimates a pretax value at $11.07 per option (about $10 of intrinsic value and $1.07 of time value). But because the company saves cash on the tax deduction, we need an aftertax value. In this case, the $11.07 becomes $6.64 as an aftertax cost ($11.07 x [1 â€“ 40% tax rate] = $6.64). Our estimate for the total aftertax costs of all of Motorola's outstanding options is just over a billion dollars.
Step No.2: Estimating the Discounted AfterTax CashFlow Cost of Future ESO Grants
The second step is to estimate the cashflow cost of current and future options grants. The annual report's footnote indicates that MOT granted just over 75 million options in that fiscal year. Let's assume this is a reasonably "normal" level of ESO grants. If we further assume a $14 stock price, a fairvalue estimate of 30% (meaning our optionspricing model says the option is worth 30% of stock price) and a 40% tax rate, then the aftertax cost of this grant is about $189 million. See step 2A below:
The aftertax cost of $189 million is only the cost of one year's grant. In step 2B we estimate the present value of a future endless stream of grants. In order to value the options grants into perpetuity, we use the Gordon Growth Model (also known as the dividend discount model) where the value of a payment stream is equal to the first payment divided by the discount rate minus the growth rate. If we assume the discount rate to be 10% and the growth rate of the cash cost of the option to be 3% per year, we get a discounted present value of $2.7 billion as in step 2B above.
Step No.3: Combining Cost of Outstanding and Future ESO Grants
If you are trying to get the most precise measure of ESO cost, the cashflow method is probably the best. Unlike the other three methods, it arrives at a more complete picture by counting all ESOs (past, present and future), by counting the relative value of ESOs and by incorporating the net cashflow impact of ESOs. However, in order to achieve this precision, the cashflow method requires some key assumptions: a fairvalue estimate of ESO grants using an optionspricing model and an estimate of the growth in future grants.
Conclusion
Employee stock options are a real cost to shareholders. Although we always know the intrinsic value of an ESO, the true cost is difficult to measure because getting at the time value of an ESO is an attempt to predict the future.
ESOs: Conclusion

Managing Wealth
Employee Stock Options (ESO)
Employee stock options are a form of equity compensation granted by companies to their employees and executives. 
Trading
Avoid Premature Exercise On Employee Stock Options
With early exercise, you forfeit some profit back to your employer, and incur income tax to boot. 
Investing
What is a Stock Option?
An employee stock option is a right given to an employee to buy a certain number of company stock shares at a certain time and price in the future.