Employee Options, Restricted Stock

and Value
AswathDamodaran

Aswath Damodaran

Basic Proposition on Options

Anyoptionsissuedbyafirm,whethertomanagementoremployees
ortoinvestors(convertiblesandwarrants)createclaimsontheequity
ofthefirm.
Bycreatingclaimsontheequity,theycanaffectthevalueofequity
pershare.
Failingtofullytakeintoaccountthisclaimontheequityinvaluation
willresultinanoverstatementofthevalueofequitypershare.

Aswath Damodaran

Why do options affect equity value per share?

Itistruethatoptionscanincreasethenumberofsharesoutstanding
butdilutionperseisnottheproblem.
Optionsaffectequityvaluebecause
Sharesareissuedatbelowtheprevailingmarketprice.Optionsget
exercisedonlywhentheyareinthemoney.
Alternatively,thecompanycanusecashflowsthatwouldhavebeen
availabletoequityinvestorstobuybackshareswhicharethenusedto
meetoptionexercise.Thelowercashflowsreduceequityvalue.

Aswath Damodaran

In the beginning

XYZcompanyhas$100millioninfreecashflowstothefirm,
growing3%ayearinperpetuityandacostofcapitalof8%.Ithas100
millionsharesoutstandingand$1billionindebt.Itsvaluecanbe
writtenasfollows:
Valueoffirm=100/(.08.03)
Debt
=Equity
Valuepershare

Aswath Damodaran

=2000
=1000
=1000
=1000/100=$10

Now come the options

XYZdecidestogive10millionoptionsatthemoney(withastrike
priceof$10)toitsCEO.Whateffectwillthishaveonthevalueof
equitypershare?
None.Theoptionsarenotinthemoney.
Decreaseby10%,sincethenumberofsharescouldincreaseby10
million
Other

Aswath Damodaran

Dealing with Employee Options: The Bludgeon

Approach

Thesimplestwayofdealingwithoptionsistotrytoadjustthe
denominatorforsharesthatwillbecomeoutstandingiftheoptionsget
exercised.
Intheexamplecited,thiswouldimplythefollowing:
Valueoffirm=100/(.08.03)
Debt
=Equity
Numberofdilutedshares
Valuepershare

Aswath Damodaran

=2000
=1000
=1000
=110
=1000/110=$9.09

Problem with the diluted approach

Thedilutedapproachfailstoconsiderthatexercisingoptionswill
bringincashintothefirm.Consequently,theywilloverestimatethe
impactofoptionsandunderstatethevalueofequitypershare.
Thedegreetowhichtheapproachwillunderstatevaluewilldepend
uponhowhightheexercisepriceisrelativetothemarketprice.
Incaseswheretheexercisepriceisafractionoftheprevailingmarket
price,thedilutedapproachwillgiveyouareasonableestimateof
valuepershare.

Aswath Damodaran

The Treasury Stock Approach

Thetreasurystockapproachaddstheproceedsfromtheexerciseof
optionstothevalueoftheequitybeforedividingbythediluted
numberofsharesoutstanding.
Intheexamplecited,thiswouldimplythefollowing:
Valueoffirm=100/(.08.03)
Debt
=Equity
Numberofdilutedshares
Proceedsfromoptionexercise
Valuepershare

Aswath Damodaran

=2000
=1000
=1000
=110
=10*10=100(Exerciseprice=10)
=(1000+100)/110=$10

Problems with the treasury stock approach

Thetreasurystockapproachfailstoconsiderthetimepremiumonthe
options.Intheexampleused,weareassumingthatanatthemoney
optionisessentiallyworthnothing.
Thetreasurystockapproachalsohasproblemswithoutofthemoney
options.Ifconsidered,theycanreducethevalueofequitypershare.If
ignored,theyaretreatedasnonexistent.

Aswath Damodaran

Dealing with options the right way

Step1:Valuethefirm,usingdiscountedcashfloworothervaluation
models.
Step2:Subtractoutthevalueoftheoutstandingdebttoarriveatthe
valueofequity.Alternatively,skipstep1andestimatetheofequity
directly.
Step3:Subtractoutthemarketvalue(orestimatedmarketvalue)of
otherequityclaims:
ValueofWarrants=MarketPriceperWarrant*NumberofWarrants :
Alternativelyestimatethevalueusingoptionpricingmodel
ValueofConversionOption=MarketValueofConvertibleBonds
ValueofStraightDebtPortionofConvertibleBonds

Step4:Dividetheremainingvalueofequitybythenumberofshares
outstandingtogetvaluepershare.

Aswath Damodaran

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Valuing Employee Options

Optionpricingmodelscanbeusedtovalueemployeeoptionswith
threecaveats
Employeeoptionsarelongterm,makingtheassumptionsaboutconstant
varianceandconstantdividendyieldsmuchshakier,
Employeeoptionsresultinstockdilution,and
Employeeoptionsareoftenexercisedbeforeexpiration,makingit
dangeroustouseEuropeanoptionpricingmodels.
Employeeoptionscannotbeexerciseduntiltheemployeeisvested.
Employeeoptionsareilliquid.

Theseproblemscanbepartiallyalleviatedbyusinganoptionpricing
model,allowingforshiftsinvarianceandearlyexercise,andfactoring
inthedilutioneffect.Theresultingvaluecanbeadjustedforthe
probabilitythattheemployeewillnotbevested.

Aswath Damodaran

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Modifications to Option pricing Model

Sinceemployeeoptionscanbeexercisedearly,acasecanbemade
thattherightmodeltouseistheBinomialmodel,sinceyoucanmake
theexercisecontingentonthestockprice.(Exerciseifthestockprice
exceeds150%ofexercisevalue,forexample).
UsingaBlackScholesmodelwithashortermaturity(halfthestated
one)andadilutionadjustmenttothestockpriceyieldsroughlysimilar
values.
Bottomline:Theargumentthatoptionpricingmodelsdoaterriblejob
atvaluingemployeeoptionsdoesnotholdwater.Eventhelousiest
optionpricingmodeldoesbetterthantheaccountingexercisevalue=
optionvaluemodel.

Aswath Damodaran

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Back to the numbers Inputs for Option

valuation

StockPrice=$10
StrikePrice=$10
Maturity=5years
Standarddeviationinstockprice=40%
RisklessRate=4%

Aswath Damodaran

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Valuing the Options

UsingadilutionadjustedBlackScholesmodel,wearriveatthe
followinginputs:
N(d1)=0.7274
N(d2)=0.3861
Valuepercall=$9.43(0.7274)$10exp(0.04)(5)(0.3861)=$3.70
DilutionadjustedStockprice

Aswath Damodaran

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Value of Equity to Value of Equity per share

Usingthevaluepercallof$5.42,wecannowestimatethevalueof
equitypershareaftertheoptiongrant:
Valueoffirm=100/(.08.03)
Debt
=Equity
Valueofoptionsgranted
=ValueofEquityinstock
/Numberofsharesoutstanding
=Valuepershare

Aswath Damodaran

=2000
=1000
=1000
=$37
=$963
/100
=$9.63

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To tax adjust or not to tax adjust

Intheexampleabove,wehaveassumedthattheoptionsdonot
provideanytaxadvantages.Totheextentthattheexerciseofthe
optionscreatestaxadvantages,theactualcostoftheoptionswillbe
lowerbythetaxsavings.
Onesimpleadjustmentistomultiplythevalueoftheoptionsby(1
taxrate)togetanaftertaxoptioncost.

Aswath Damodaran

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Option grants in the future

Assumenowthatthisfirmintendstocontinuegrantingoptionseach
yeartoitstopmanagementaspartofcompensation.Theseexpected
optiongrantswillalsoaffectvalue.
Thesimplestmechanismforbringinginfutureoptiongrantsintothe
analysisistodothefollowing:
Estimatethevalueofoptionsgrantedeachyearoverthelastfewyearsas
apercentofrevenues.
Forecastoutthevalueofoptiongrantsasapercentofrevenuesintofuture
years,allowingforthefactthatasrevenuesgetlarger,optiongrantsasa
percentofrevenueswillbecomesmaller.
Considerthislineitemaspartofoperatingexpenseseachyear.Thiswill
reducetheoperatingmarginandcashfloweachyear.

Aswath Damodaran

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When options affect equity value per share the

most

Optiongrantsaffectvaluemore
Thelowerthestrikepriceissetrelativetothestockprice
Thelongerthetermtomaturityoftheoption
Themorevolatilethestockprice

Theeffectonvaluewillbemagnifiedifcompaniesareallowedto
revisitoptiongrantsandresettheexercisepriceifthestockprice
movesdown.

Aswath Damodaran

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The Agency problems created by option

grants

TheVolatilityEffect:Optionsincreaseinvalueasvolatility
increases,whilefirmvalueandstockpricemaydecrease.Managers
whoarecompensatedprimarilywithoptionsmayhaveanincentiveto
takeonfarmoreriskthanwarranted.
ThePriceEffect:Managerswillavoidanyaction(evenonesthat
makesense)thatreducethestockprice.Forexample,dividendswill
beviewedwithdisfavorsincethestockpricedropsontheexdividend
day.
TheShorttermEffect:Totheextentthatoptionscanbeexercised
quicklyandprofitscashedin,therecanbeatemptationtomanipulate
informationforshorttermpricegain(Earningsannouncements)

Aswath Damodaran

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The Accounting Effect

Theaccountingtreatmentofoptionshasbeenabysmalandhasledto
themisuseofoptionsbycorporateboards.
Accountantshavetreatedthegrantingofoptionstobeanonissueand
keptthefocusontheexercise.Thus,thereisnoexpenserecordedat
thetimeoftheoptiongrant(thoughthefootnotesrevealthedetailsof
thegrant).
Evenwhentheoptionsareexercised,thereisnouniformityinthe
waythattheyareareaccountedfor.Somefirmsshowthedifference
betweenthestockpriceandtheexercisepriceasanexpensewhereas
othersreducethebookvalueofequity.

Aswath Damodaran

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The times, they are changing.

In2005,theaccountingrulesgoverningoptionswillchange
dramatically.Firmswillberequiredtovalueoptionswhengranted
andshowthemasexpenseswhengranted(thoughtheywillbe
allowedtoamortizetheexpensesoverthelifeoftheoption)
Theywillbeallowedtorevisittheseexpensesandadjustthemfor
subsequentnonexerciseoftheoptions.Thiswillleadtorestatement
ofaccountingearnings.
Anychangesintheoptioncharacteristicswillleadtoareassessment
oftheoptionexpenseandanadjustmentintheyearofthechange.

Aswath Damodaran

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Leading to predictable moaning and groaning..

Themanagersoftechnologyfirms,whohappentobetheprime
beneficiariesoftheseoptions,havegreetedtheserulechangeswiththe
predictablecomplaintswhichinclude:
Theseoptionscannotbevaluedpreciselyuntiltheyareexercised.Forcing
firmstovalueoptionsandexpensethemwilljustresultininimprecise
earnings.
Firmswillhavetogobackandrestateearningswhenoptionsare
exercisedorexpire.
Firmsmaybeunwillingtouseoptionsasliberallyastheyhaveinthepast
becausetheywillaffectearnings.

Aswath Damodaran

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Some predictions about firm behavior

Iftheaccountingchangesgothrough,wecananticipatethefollowing:
Adeclineinequityoptionsasawayofcompensatingemployeesevenin
technologyfirmsandaconcurrentincreaseintheuseofconventional
stock.
Agreaterawarenessoftheoptioncontractdetails(maturityandstrike
price)onthepartofboardsofdirectors,whonowwillbeheld
accountableforthecostoftheoptions.
Atleastinitially,wecanexpecttoseefirmsreportearningsbeforeoption
expensingandafteroptionexpensingtoallowinvestorstocomparethem
topriorperiods

Aswath Damodaran

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And market reaction

Akeytestofwhethermarketsarealreadyincorporatingtheeffectof
optionsintothestockpricewilloccurwhenallfirmsexpenseoptions.
Ifmarketsareblindtotheoptionoverhang,youcanexpectthestock
pricesofcompaniesthatgrantoptionstodropwhenoptionsare
expensed.
Themorelikelyscenarioisthatthemarketisalreadyincorporating
optionsintothemarketvaluebutisnotdiscriminatingverywell
acrosscompanies.Consequently,companiesthatuseoptions
disproportionately,relativetotheirpeergroups,shouldseestock
pricesdecline.

Aswath Damodaran

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Options in Relative Valuation

MostvaluationsontheStreetarerelativevaluations,wherecompanies
arecomparedonthebasisofamultipleofearnings,bookvalueor
revenues.
Whileitmayseemthatyouareavoidingtheoptionsproblemin
relativevaluation,youarenot.Infact,whenyoucomparePEratiosor
EV/EVITDAmultiplesacrosscompanies,youaremakingimplicit
assumptionsaboutoptionsatthesecompanies.Inmanycases,youare
assumingthattheoptionoverhangisthesameatallofthecompanies
inyourcomparablelist.

Aswath Damodaran

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Bringing options into the picture

Youcanusedilutedsharesincomputingearningspershareandhope
thatthiscapturesoptionsoutstanding.
Youcanlookatoptionsoutstandingasapercentofoutstandingstock
anduseitasaqualitativevariable.Firmswithmoreoptions
outstandingshouldtradeatlowerearningsmultiples.
Youcancomputethevalueofoptionsoutstandingandcomputingthe
earningsmultipleusingtheaggregatevalueofequity(marketcap+
optionsoutstanding).

Aswath Damodaran

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Restricted Stock

Intheaftermathofthechangeinaccountingtreatmentofoptions,
manyfirmshaveswitchedtothepracticeofgivingemployeesstock
withrestrictionsontrading.
Theserestrictedstockareeasiertodealwiththanemployeeoptions.
Theonlyissueisthediscounttobeappliedtothestockbecauseofthe
tradingrestrictions.
Theilliquiditydiscountappliedtoprivatefirmsshouldprovidean
indicator.Generally,theilliquiditydiscounthasrangedfrom1020%/

Aswath Damodaran

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The Valuation Impact

RestrictedStockalreadyissued:Valuetheaggregateequityinthe
company.Togetthevaluepershare:
Conservatively:Assumenoilliquiditydiscountanddividebythetotal
numberofshares(includingrestrictedstock)outstanding.
Morerealistically:Assumeanilliquiditydiscount(asa%)onthevalue
andsolveforthevaluepershareofthestock.Forinstance,ifthevalueof
equityis$100millionandthereare8millionregularsharesand2
millionrestrictedsharesoutstandingandtheilliquiditydiscountis10%.
Valuepershare=100/(8+(10.1)2)=$10.20

Expectedfutureissues:Estimatethevalueofrestrictedstockgrantsas
apercentofrevenuesandbuildintooperatingexpenses.

Aswath Damodaran

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Employee Equity: Closing Thoughts

Itisagoodideatogiveemployeesanequitystakeinthefirmsthat
theyworkin.However,beclearthatthisequitystakeisbeingfunded
bytheexistingstockholdersofthefirmandislikeanyotheremployee
expense.
Thereisacosttomakingemployeesintostockholdersbygivingthem
stock.Theymayhavetoomuchinvestedinthefirmandbecomemore
riskaverseasaconsequence.
Ontheothersideoftheledger,optionsarenotequivalenttocommon
stock.Theyincreaseinvaluewithvolatilityandcanencouragerisky,
shorttermbehaviorinmanagers.

Aswath Damodaran

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