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.
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