ESOs: Conclusion
  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: Conclusion

By David Harper

Most public companies grant stock options (ESOs) to their employees, and almost everybody agrees that ESOs represent a cost to shareholders, or, to put it differently, that ESOs dilute the ownership of current shareholders. Because of this cost, accounting rules will probably require companies to expense ESOs in order to increase the accuracy of reported profits. There is, however, little consensus on how to calculate the cost of ESOs. As we have throughout this tutorial, any estimate will be imprecise because capturing the full cost of ESOs always requires making assumptions about unknown future events, such as the movement of the stock price, employee turnover and employee exercise behavior.

Because of these assumptions, it is beneficial for investors to understand how accounting rules treat ESOs, and how to improve the accounting numbers to get a clearer picture of the economic impact of ESOs on the valuation of the company. Here is a summary of the perspectives on ESOs that this tutorial covers:

  • Diluted EPS is a good start, but it will always underestimate the true cost of ESOs because it omits the time value of all options and therefore does not incorporate out-of-the-money ESOs.
  • For accounting purposes, the Black Scholes Model is currently the most popular options-pricing model, but it was designed for options that trade on an exchange and will therefore probably be replaced by the more versatile binomial model.
  • For valuation purposes, economic overhang - an improvement over the popular equity overhang - is a good way for investors to assess the dilution impact of ESOs. Finally, the cash-flow method is probably the best, if you have the time to compute it.

  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
RELATED TERMS
  1. Employee Stock Option - ESO

    A stock option granted to specified employees of a company. ESOs ...
  2. Cashless Exercise

    A transaction that is used when exercising employee stock options ...
  3. Overhang

    A measure of the potential dilution to which a common stock's ...
  4. Dilution

    A reduction in the ownership percentage of a share of stock caused ...
  5. Option Pricing Theory

    Any model- or theory-based approach for calculating the fair ...
  6. Binomial Option Pricing Model

    An options valuation method developed by Cox, et al, in 1979. ...
RELATED FAQS
  1. What are the SEC regulations on exercising stock options?

    Learn how the SEC and IRS regulate employee stock options, including the exercise of options and the sale of options, and ... Read Answer >>
  2. What is dilutive stock?

    Dilutive stock is any security that dilutes the ownership percentage of current shareholders - that is, any security that ... Read Answer >>
  3. What is a vest fleece?

    A vest fleece is a term first coined by Jack Ciesielski, founder of The Analyst's Accounting Observer, and it relates to ... Read Answer >>
  4. What is the average return on equity for a company in the electronics sector?

    Learn about the Black-Scholes option pricing model and the binomial options model, and understand the advantages of the binomial ... Read Answer >>
  5. Why is a company's diluted EPS always lower than its simple EPS?

    Learn about diluted and basic earnings per share and why a company's diluted earnings per share is usually lower than its ... Read Answer >>
  6. How do you calculate diluted EPS using Excel?

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