RESEARCH FOUNDATION OF CFA INSTITUTE MONOGRAPH. Employee Stock Options and Equity Valuation

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1 Research Foundation of CFA Institute Monograph 91 RESEARCH FOUNDATION OF CFA INSTITUTE MONOGRAPH Employee Stock Options and Equity Valuation Mark Lang Research Foundation of CFA Institute Monograph (2004) Employee stock options have become a large component of compensation for many companies, especially those in which human capital forms a large portion of company assets. How to account for such compensation is currently a hot topic in academic and management circles because the method chosen has implications for how a company should be valued. In this Research Foundation of CFA Institute monograph, the author addresses how to value the equity of companies that grant employee options. He discusses prior research on this topic, presents a discounted cash flow model that begins with free cash flow, and introduces costs associated with current and future options as well as the incentive benefits of granting options. Although the modified Black Scholes model has been criticized for having unrealistic assumptions, the author deems it well-suited in practice for valuing employee stock options. The author provides the reader with a review of the usual features of employee stock options and a straightforward approach for incorporating options into the equity valuation process. He notes that employee stock options issued at the money have value even though the Financial Accounting Standards Board s (FASB s) intrinsic value approach assumes they are worthless. More important, he shows that the benefit to the employee comes at the expense of the existing shareholders. Of course, options also have cash flow and valuation consequences, both good and bad, for a company and its shareholders. Not only must the effects of currently granted options be considered, but the effects of future options must also be considered. The author s Mark Lang is at the Kenan-Flagler Business School at the University of North Carolina. The summary was prepared by Frank T. Magiera, CFA.

2 92 CFA Digest August 2004 valuation model starts with free cash flow and includes each component in a present value framework: Value of common equity = PV(Expected pre-option operating free cash flows) Existing debt PV(Expected cost of existing options) PV(Expected cost of future options) + PV(Expected incremental cash flows from options). The author reviews accounting and disclosure for stock options. He follows with procedures for valuing options and illustrates the process by estimating the effect of employee stock options on Dell Computer Corporation for the 2002 fiscal year. Accounting and disclosure issues primarily deal with arguments regarding whether options should be expensed and if expensed, determining the appropriate model to use. Accounting Principles Board No. 25 recognized that options have value, but because of the inadequacy of model development in 1973, intrinsic value on the grant date was the approach chosen for expensing. Options granted at the money thus had no value, and option expense did not appear in the profit/loss statement. Subsequently, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation and offered the alternative of disclosure rather than expensing. To illustrate the computation of option costs, the author estimates the value of outstanding options for Dell using the Black Scholes model. He then estimates the value of future option costs. Together, current and future option obligations were estimated to be $23.1 billion compared with the yearend market capitalization of $69.7 billion. A final consideration is the potential substantial tax effects of options. For nonqualified options, two tax issues appear. First, tax treatment is based on exercise-date accounting whereas financial accounting is based on the grant date. Second, the amount of option cost deduction can be very large for companies that experience large increases in stock price. Of course, one cannot assume large deductions can always be used by companies experiencing losses, and the author addresses this issue and the tax effects on cash flows. The author notes that NASDAQ 100 companies had pretax income of $13 billion before option deductions in 2000 but had $35 billion in option deductions. Any approach to employee stock option valuation must make assumptions about the behavior employees will follow as they exercise 2004, CFA Institute

3 Research Foundation of CFA Institute Monograph 93 their options. The traditional Black Scholes model for traded options implies that early exercise is not optimal for non-dividend-paying stocks, but that is not the case for nontraded employee stock options. This difference also reflects the fact that, unlike traded options, employee options cannot be sold or hedged; hence, the risk profile and liquidity needs of the employee must be taken into account. The author delves into the issue of how the risk-averse nature of employees affects the patterns of option exercise. He discusses the empirical evidence, including the findings of Huddart and Lang (Journal of Accounting and Economics, 1996). Among these are the indications that early exercise is pervasive and that employees sacrifice as much as one-half the theoretical Black Scholes value by exercising early, suggesting significant risk aversion on their part. Of special interest is the finding that early exercise is negatively related to future returns, suggesting insiders have private information about future company prospects and exercise prior to negative information coming to the market. Early exercise influences the choice of the appropriate option-valuation model. Generally, companies following SFAS No. 123 use the modified Black Scholes model with the assumption that all exercise occurs in the average exercise year. The author discusses the use of different exercise points as well as other factors that affect option valuation. Some research indicates that, although the Black Scholes model ignores theoretically important considerations, it appears to value options without serious bias and performs nearly as well as more complex models that explicitly incorporate risk aversion. He deems the model well suited for estimating the value of option obligations and outlines its potential for bias. Risk aversion and portfolio diversification are at the heart of how option value is perceived by employees. One result of granting options is that many employees end up holding poorly diversified portfolios and thus incur greater risk exposure than they would like. Usually, employees cannot lay off the risk by selling the options or by using such hedging techniques as shorting the underlying stock. If employees could sell the options, the value to employees would increase but the incentive value to the company would no longer exist. The difference between the theoretical value of the option (cost to the company) and the perceived value to the employee represents a

4 94 CFA Digest August 2004 deadweight loss potentially made up by the incentive effects of the option. The author notes that option granting is not optimal if the incentive effect does not justify this loss. He discusses some paradoxical observations on incentives when option value to the employee differs from its cost to the company. One observation is that removal of vesting requirements would be of lower cost to the employer and provide higher value to employees because they would exercise earlier. Volatility also is a factor for risk-averse employees. He documents that increasing volatility increases the gap between the cost of the option and the perceived value to undiversified managers. For example, managers of Internet companies were estimated to value options at about 53 percent of their cost to the company. This observation has valuation implications because it suggests other forms of compensation might be more optimal than options for both the employee and the company especially for lower-level employees whose efforts might be perceived to have little effect on the stock price. The author asks why companies would issue options if cost exceeds the incentive benefits. The answer lies in the possibility that such decisions are driven by accounting considerations. Accounting rules do not require expensing for options granted at the money, as is widely done. He also discusses the relationship between accounting rules, compensation design, and option repricing. The author discusses a variety of other topics that affect equity valuation. These include the link between future cash flows and stock repurchases to avoid dilution. Such activity has an effect on cash flows and a company s ability to fund positive net present value projects in the future. Dilution also calls for discussion of the appropriate way to incorporate options in EPS and other valuation calculations. Options have an incentive effect on decisions regarding company investments and risk taking. The author discusses the challenge of researching such incentive effects and considers how the equity market values companies granting options. The author summarizes the issues involved in valuing equity when employees are granted stock options. The easiest way to structure the valuation problem is to begin with a basic discounted cash flow analysis and then explicitly introduce options as provided in the author s common equity valuation expression. The author reiterates 2004, CFA Institute

5 Research Foundation of CFA Institute Monograph 95 that, although the modified Black Scholes model has been criticized for unrealistic assumptions, it appears to perform reasonably well in practice at valuing stock options. He discusses future option issues, such as the current proposals to mandate option expense recognition, and the impending shift from stock options to restricted stock in anticipation of such an accounting change. Keywords: Advocacy, Regulatory, and Legislative Issues: regulatory and legislative issues; Equity Investments: fundamental analysis and valuation models; Financial Statement Analysis: accounting and financial reporting issues; Financial Statement Analysis: financial accounting standards and proposals