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

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.

Related Articles
  1. Managing Wealth

    Employee Stock Options (ESO)

    Employee stock options are a form of equity compensation granted by companies to their employees and executives.
  2. Trading

    Expensing Employee Stock Options: Is There A Better Way?

    In 2009, Senators Carl Levin and John McCain introduced a bill to stop the excessive deductions for ESOs. But is there another solution?
  3. Managing Wealth

    Accounting and Valuing Employee Stock Options

    Learn the different accounting and valuation treatments of ESOs, and discover the best ways to incorporate these techniques into your analysis of stock.
  4. 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.
Frequently Asked Questions
  1. What's the best-selling iPhone model of all time?

    The best-selling iPhone model remains the iPhone 6 and the larger iPhone 6+, though they're now two generations old.
  2. Who are Chipotle's (CMG) main competitors?

    Learn about Chipotle's four main competitors in the fast casual dining sector of the restaurant business, and how fast casual ...
  3. Who are Disney's (DIS) Main Competitors?

    Learn about how creating entertainment has been Disney's niche since the 1920s, even as it faces ever-increasing competition ...
  4. Who are Apple's (AAPL) Main Competitors in the Tech Industry? (HPQ)

    Explore Apple's competitive position in the many industries in which it operates. Learn about the different products and ...
Trading Center