Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

EMPLOYEE STOCK OPTION BASICS

To frame the discussion of options and equity valuation, it is useful to consider typical features of employee stock options and a basic approach for incorporating options in valuation. In this section, I develop a simple option example to highlight the economic implications of options for existing equityholders. Then, I apply the implications from the example to a standard discounted cash flow model to highlight the effect employee options can have on equity valuation. In later sections, I use the insights from the option example and equity valuation equation to emphasize the importance of the research findings for equity valuation.

A Typical Employee Option

Although the length of term varies across companies, a typical option has a 10-year life. Furthermore, the typical option is granted at the money, meaning that the strike price at which the option can be exercised is equal to the stock price at the time of the grant. Therefore, if the stock remains below the price at grant date throughout its life, the option will expire valueless and the employee will have gained nothing. If the stock increases in value, however, the employee has the right to exercise the option and receive the shares at the strike price specified in the option agreement. Typically, an option also carries a vesting period and schedule, such as 25 percent per year at the end of each of the first four years of the option’s life, limiting exercise until vesting has occurred. As do ...