TAILIEUCHUNG - Employee Stock Options (ESOPs) and Restricted Stock: Valuation Effects and Consequences

In addition to an annual investor relations programme, companies should retain a financial public relations adviser. As well as targeting private client brokers, they are vital in terms of honing the message to investors and the media and in gaining media coverage in the right places, at the right time. National newspapers give increasingly less space to routine company news and results, whereas there is a wide range of magazines and websites targeted specifically at private investors. Again, coverage in these can be crucial in terms of stimulating interest in, and demand for, a company’s shares from private investors. The. | 1 Employee Stock Options ESOPs and Restricted Stock Valuation Effects and Consequences Aswath Damodaran Stern School of Business September 2005 2 Management Options and Restricted Stock Valuation Effects and Consequences In the last decade firms have increasingly turned to offering employees options and restricted stock often with restrictions on trading as part of compensation packages. Some of this trend can be attributed to the entry of young cash poor technology firms into the market many of which have to use equity because they have no choice. However many larger market cap firms that can afford to pay cash compensation have used stock based compensation as a way of aligning managerial interests with stockholder interests. In this paper we begin by looking at motives good and bad for using equity based compensation and trends over the last few years. We then turn to the accounting rules old and new that govern how equity compensation is recorded and reported. Finally we consider how best to incorporate employee options and restricted stock - both past and prospective - into discounted cash flow and relative valuation models. 3 In recent years many firms have shifted towards equity-based compensation for their employees. It is not uncommon for firms to grant millions of options annually not only to top managers but also to lower level employees. These options create a potentially value decreasing overhang over common stock values. What used to be a simple practice of dividing the estimated equity value by the number of shares outstanding to arrive at value per share has become a daunting exercise. Analysts struggle with how best to adjust the number of shares outstanding and the value per share for the possibility that there will be more shares outstanding in the future. They attempt to capture this dilution effect by using the partially diluted or fully diluted number of shares outstanding in the company. As we will see in this paper these approaches often .

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