*** REVISED ***

Spring 2009 NBA 5060

Lecture 12 – Valuation of Employee Stock Options

1. Theory

2. Adjusting valuation for the presence of employee stock options

3. Example: Sportsman’s Guide

Lecture 12 Page 1 of 15
Valuation of the firm

One method to arrive at a value of the equity is the following:

Vi,t = Present Value of Free Cash Flows to the Firm – Value of Debt

Conceptually, why do we subtract debt from this valuation?

You can think of employee stock options equivalently. To the extent that
employees holding options are viewed as additional claims on the residual
cash flows of the firm, we need to deduct the value of employee stock
options to arrive at the value of common equity. However, this requires
some knowledge of option valuation and the peculiarities of employee stock
options.

Therefore, you can compute the free cash flows to the equity as we have in
the past, but subtract out the value of options to arrive at a value for current
common equity. Thus, all we need to do is estimate the value of the
employee stock options

Lecture 12 Page 2 of 15
The Option Overhang

The option overhang is the number of options outstanding divided by the

number of shares outstanding. It measures the extent of option usage by a
company. The average option overhang for US publicly traded companies
over the last five years is:

2004 2005 2006 2007 2008

Options outstanding
16.02% 13.35% 13.12% 8.89% 9.15%
Shares outstanding

Why not use employee stock option expense under SFAS 123R?

All firms are required to recognize Stock Option Expense for their option
grants under SFAS 123R starting in 2006.

How is option expense computed under 123R?

Lecture 12 Page 3 of 15
Adjusting DCF/RIM Values for ESOPs

To value the cash flows to current equity holders, we can think of the two
pieces we need to estimate:

Equity Value to = Total Equity Value - Value of Current Options

Current Colders (Pre ESO) Outstanding

Recognize, however, that there are features of employee stock options that
reduce the value of these options (relative to traded options).

We will substitute expected time to exercise for time to expiration to

account for this.

Lecture 12 Page 4 of 15
Tax Benefits and Employee Stock Options: NSO vs ISO.

Non-qualified stock options provide a tax benefit to the firm, while incentive
stock options do not.

Tax Benefit
ISO 0
ISO with disqualifying dispositions *(P – X)
NSO τ*(P – X)

Therefore, the firm receives a deduction which provides an additional cash

flow to the firm. Thus, the value of the outstanding options is the outflow to
the employees, less the tax benefit received by the firm. The aggregate tax
benefit received by the firm at date of exercise will equal:

TBexercise = ne * (Pe - X) *τ*p

Where p equals the proportion of options generating a tax deduction, Pe is

price at exercise date, X is strike price, and τ is marginal tax rate (can use
statutory).

Consequently, we need to know the proportion of options that are treated

as ISOs versus the proportion treated as NSOs.

Lecture 12 Page 5 of 15
Because the tax benefit is only generated on NSOs and non-qualified
dispositions, we can estimate p (using historical data) as follows:

TBe
p=
ne * ( Pe − X )* τ

Therefore, the value of options should be adjusted for the offsetting tax
benefit received by the firm as follows:

Impact of current options outstanding = Aggregate current value * (1 - τ*p)

This information is available in the financial statements, except for Pe,

which is readily available elsewhere.

Lecture 12 Page 6 of 15
Example: Sportsman’s Guide

Assume average price for fiscal 2004 was $15/share, the tax benefit from
employee stock options was $1.07M, the number of options exercised is
291,599, average strike price is $3.75 and τ=36.2%

What is estimate of p?

Lecture 12 Page 7 of 15
Estimating value of current options outstanding

This approximation uses the inputs given to you by the firm. We want a
value for the total number of options currently outstanding. We’ll use the
Black-Scholes method, and use the firms estimate of the expected lives of
these options to account for early exercise issues, etc.
The Black-Scholes Formula

N(x) is the cumulative probability distribution function for a

standardized normal distribution, values of which are commonly
found in published tables.

Black - Scholes Inputs

σ = Volatility of the change in stock price
rf = Risk-free rate
T = Expected life of the option
S0 = Stock price at grant date
K = Exercise price
q = Dividend yield (as a % of stock price)

Lecture 12 Page 8 of 15
Most of these parameters are available in the SFAS 123 disclosure (option
footnote), except for current share price.

You can either use current share price or implied value for this calculation
(what is implied by using each of these measures?).

Lecture 12 Page 9 of 15
If you use the value estimated from your DCF analysis in place of the
current price in the Black-Scholes model, note that this introduces
circularity into the model.

To address this concern, be sure that you allow your model to iterate to the
correct solution, or use the pre-ESOP valuation as your input.

Finally, be sure that option values are adjusted to after-tax amounts, using
the τ parameter and the p parameter calculated on page 6.

Final equity value will be computed just as before, minus the adjustments
for current options outstanding.

Lecture 12 Page 10 of 15
Lecture 12 Page 11 of 15
Example: Sportsman’s Guide
This estimates the value of future option grants. This is needed for Sportsman’s Guide because FAS 123R did not apply at the time, so no
option expense was recorded on the historical financial statements. Going forward, option expense is recognized, usually as part of
SG&A. Therefore, your forecasts will implicitly include the effects of future option grants because historical SG&A is generally used as
a starting point in forecasting future SG&A.

Employee Stock Options 2004 2005 2006 2007 2008 2009 2010 2011 2012
Number of options granted 736,500
Future Grant as %
Black Scholes Fair Value at Grant Date of Revenue 2.500% 2.278% 2.056% 1.833% 1.611% 1.389% 1.167% 0.944%
$ Value of Grants (000s) $ 6,931 Future Grant Value $ 8,340 $ 9,103 $ 9,063 $ 8,610 $ 7,946 $ 7,152 $ 6,257 $ 5,271
As % of Revenue 2.981% After Tax Value $ 5,620 $ 6,134 $ 6,107 $ 5,802 $ 5,354 $ 4,819 $ 4,216 $ 3,552
Proportion of NSO Options 90.10%
NPV of Future Option Grants $ 37,248.96

Black Scholes Valuation of Current Options Outstanding

Number Out Wtd Avg Strike rf Volatility Time Div. Yield Stock Price d1 d2 BSV
Value of Outstanding Options 2,014,318 8.29 2.87 48 4 0 $25.50 1.7700297 0.8100297 18.68
Total Black Scholes Value after tax (000) $ 25,354.48

Summary of Effect of ESOPs

Present Value of future grants (after tax) $ 37,248.96
Value of current options outstanding (after tax) $ 25,354.48
Total cost of employee stock options (000): $ 62,603.43

Effect of ESOPs on value per share $ (8.42)

Effect of ESOPs on value per share, date adjusted $ (9.57)

Value per share $ 17.64
Equity value per share, after ESOPs $ 8.07

Lecture 12 Page 12 of 15
 This estimates the value of current options outstanding. This is needed to reflect the fact that options outstanding are a contingent claim on
future cash flows to equity holders, thereby reducing the value to current equity holders today. This is still needed under FAS 123R.

Lecture 12 Page 13 of 15
 A Supplemental Note on Accounting for Stock Options under FAS 123(R)

Option Compensation and Tax Expense over the vesting period

FAS 123(R) changes the way companies account for non-qualified stock options (NSOs) granted to
employees. Under the new rules, companies measure the fair value of the options at the time of grant and
recognize the fair value as Option Compensation Expense in equal increments over the vesting period of
the options. The vesting period is the period over which the employee is to perform services for the
company in exchange for receiving the options. Options cannot be exercised until after the vesting period.

Example: On January 1, 2007, ABC Corp. issued one million options to employees with a total fair
value of $12 million. The options vest in three years. On the income statement, ABC Corp. reports
Option Compensation Expense equal to $4 million ($12 million fair value/3 year vesting period) for
each of the years 2007, 2008, and 2009.

Each year that a company records Option Compensation Expense, the company also records a reduction
to Tax Expense. Because the deduction cannot be claimed on the tax return until the options are
exercised, which is after the vesting period, the company also records a Deferred Tax Asset (DTA).

Example: If the tax rate is 35%, then ABC Corp. records a reduction to Tax Expense and an increase
in Deferred Tax Asset for each of the years 2007, 2008, 2009 for $1.4 million (35% x $4 million of
Option Compensation Expense). The company records the following entries for Option Compensation
Expense and Tax Expense:

For 2007, 2008, 2009:

Option Comp. Exp.* 4,000,000
Paid-In Capital 4,000,000

* ($12 million fair value/3 year vesting period) Deferred Tax Asset-Options
1/1/2007 $0
DTA 1,400,000 2007 $ 1.4 M
Tax Exp.* 1,400,000 2008 $ 1.4 M
2009 $ 1.4 M
* ($4,000,000 Stock Comp. Exp. x 35% tax rate) 12/31/2009 $ 4.2 M

At Exercise
The company records no compensation or tax expense effect at the time of exercise. The company does,
however, eliminate the DTA associated with the options and recognize the realized tax benefit, which
reduces the current period tax liability. The tax benefit of employee stock options (TBESO) equals the fair
market value of the stock at exercise minus the exercise price, multiplied by the tax rate:

TBESO = (MV of the stock – Exercise price of the option) x tax rate

TBESO is the total amount of the tax benefit from the exercise of options in the current period. Prior to
FAS 123(R), the entire TBESO was reported in the operating section. Thus, the analyst would reclass the
entire TBESO from operating to financing. Under FAS 123(R), the TBESO is split into a DTA effect and an
Excess Tax Benefit (ETB). If the difference between the market value of the stock and the exercise price
of the option is greater than the fair value of the options at the grant date, then the TBESO will be greater
than the DTA that was recorded over the vesting period. The excess of the TBESO over the DTA is called
the Excess Tax Benefit.

Example: Assume that all one million ABC Corp. options are exercised in 2010. The exercise price of
each option is $10 and the trading price of ABC’s stock at the time of exercise is $25. In this case,
TBESO = ($25 – $10) x 0.35 = $5.25 per option x 1 million options = $5.25 million. Over the years
2007, 2008, and 2009, ABC Corp. recorded DTA of $4.2 million ($1.4 million each year). Thus, the
Excess Tax Benefit equals $1.05 million ($5.25 million – $4.2 million). ABC Corp. records the following
entries at exercise:
Lecture 12 Page 14 of 15
 In 2010, at exercise:

Cash 10,000,000
Equity-C/S 10,000,000
Deferred Tax Asset-Options
1/1/2007 $0
Tax Payable 5,250,000 2007 $ 1.4 M
DTA* 4,200,000 2008 $ 1.4 M
Equity-ETB 1,050,000 2009 $ 1.4 M
2010 $4.2 M
* $4,200,000 = $1,400,000 x 3 years 12/31/2010 $0

Statement of Cash Flows: The total TBESO is the amount the analyst wants to appear in the financing
section of the statement of cash flows. Before FAS 123(R), the total TBESO was reported in the operating
section, so the analyst would reclass the entire TBESO to financing. Under the new rules, TBESO is split
into a change in DTA and Excess Tax Benefit. The Excess Tax Benefit is reported as a cash inflow from
financing activities. The operating section includes all changes in DTA in reconciling Net Income to Cash
Flows from Operations, and many items other than options can affect DTA during a year. Thus, the
analyst must manually compute the change in the DTA attributable to options exercised in the current
period. The new rules require the total TBESO to be disclosed in the notes, so the analyst can compute
the change in DTA due to exercised options:

Change in DTA = TBESO (from notes) – Excess Tax Benefit (from SCF)

Once the analyst computes the change in DTA, the analyst can subtract this amount from CFO and add it
to CFF. The analyst should do this before conducting the cash flow analysis.

Example: The total TBESO is 5.25 million, and this is the amount the analyst wants to appear in the
financing section. The Excess Tax Benefit ($1.05 million) is already reported in the Financing section
under the new rules. The analyst computes the change in DTA for 2010 using total TBESO ($5.25
million) from the notes less the Excess Tax Benefit ($1.05 million), and reclassifies this amount ($4.2
million) from the operating section to the financing section.

Other issues:

FAS 123(R) applies to ‘large’ companies for fiscal periods starting after June 15, 2006. Large companies
are companies with greater than $25 million in either market capitalization or revenues. All public
companies (large and small) must apply FAS 123(R) for periods beginning after December 15, 2006.

For the first year that a company implements FAS 123(R), most companies will likely have little or no
difference between TBESO and ETB. This is because a difference between TBESO and ETB only arises
if compensation expense has been recognized in previous periods for the options that are being
exercised. Because most options have a vesting period of a year or more, options exercised in the first
year of FAS 123(R) will not be associated with any previously recognized compensation expense.

What if the TBESO is less than the amount recorded in the DTA? This occurs if (Stock Price – Exercise
Price) is less than the fair value of the options at the grant date. In that case, ETB equals zero and the
TBESO reported in the notes would be the amount to reclass from operating to financing.

Lecture 12 Page 15 of 15