Value of outstanding stock options
Home Overview Introduction About Expectations Investing Why It Works Frequently Asked Questions Articles Mauboussin on Strategy The Consilient Observer. The Book Excerpts from the Book Special Site Extras Endorsements Value Authors About the Authors Contact the Authors Interview with the Authors Tools and Other Resources Online Tutorial Introduction Online Tutorials Online Footnotes Recommended Books Buy the Book Search Online Tutorial 6: How Do You Calculate The Cost of Employee Stock Options? We discuss the impact of Employee Stock Options ESOs in the Appendix to Chapter 5, entitled "Employee Stock Options and Expectations Investing. In this tutorial, we give further detail and provide data sources for the analysis of Microsoft's ESOs. In particular, we drill down outstanding two primary ways in which ESOs can affect the expectations investing process:. Already issued and currently outstanding ESOs represent options economic liability from the perspective of shareholders. Thus, you must subtract outstanding ESOs, like debt, from corporate value to derive shareholder value. Options to be granted in the future represent an economic cost that you must subtract from future cash flows. Value walk through both calculations below. Readers who want to calculate the cost of ESO for this Microsoft case study may also wish to download the accompanying spreadsheet. Please note that certain numbers in this tutorial may differ slightly from the book, as we have incorporated stock additional steps in this value detailed analysis. Stock example, in this exercise, we adjust for the fact that ESOs are really a "warrant. Readers who want to analyze the cost of Gateway's ESOs may wish to download this spreadsheet. Finally, readers interested in exploring this subject further may be interested outstanding a lengthy CSFB Equity Research Report on ESOs -- entitled "A Piece of the Action" -- that can be downloaded by stock here. We can value the economic liability that outstanding stock options using information dislosed in a company's Annual Report. Outstanding, we walk through this calculation, using Microsoft outstanding a case study. The first step is to value the ESOs using the Black-Scholes option pricing method. To calculate the Black-Scholes value, we must combine this information with our estimates of the following six parameters for each group:. Enter the stock price in cell C29 of the "Inputs" worksheet and the date in cell C To find these data, we can consult the Microsoft Investor Relations web site and look on page 13 of the Financial Review section in the fiscal annual report. Specifically, look at the table under options text "For various price ranges, weighted average characteristics of outstanding stock options at June 30, were as follows. In addition outstanding the number of options granted and the weighted average exercise price, stock is also necessary to note the " expected life of the options. Note that we are using the option's contractual life, not its expected life. The appropriate risk-free rate is the rate outstanding with the risk-free zero-coupon security with the same maturity as the option. In practice, using the rate of return on five-year government treasury bonds will come close to this number. Sources for the ten-year treasury bond include:. Another common practice is to use the risk-free rate assumed by the outstanding. While this may be an acceptable shortcut, the value of ESOs may change if rates fluctuate or if the company picks a inappropriate risk-free rate. You can find the company's assumed risk-free rates in the last paragraph of page 13 of the Financial Review section in the fiscal annual report. Transcribe this number into cell C30 of the "Inputs" worksheet. This number should be entered into cell C31 of the "Inputs" worksheet. Companies disclose their own estimate of volatility, which can serve as the starting point for this analysis. This data point can also be found in the last paragraph of page 13 of the Financial Review section in the fiscal annual report. Alternatively, this assumption can be relaxed by assuming the dividend yield is zero and lowering stock stock price by the present value of future dividend payments expected during the life of the option. We can find the dividend for any stock at many sources including Yahoo and CBS Marketwatch. Enter the dividend in dollars into cell C32 of the "Inputs" worksheet. The company also discloses the inputs it uses to calculate the Black-Scholes value of its annual option grants. At first glance, it seems we should multiply this value stock the number of outstanding options and have our answer. However, we must make a number of additional and potentially major adjustments:. Employees leaving before their options vest. Most firms use ESOs as a tool to retain valuable employees. Thus, options are typically structured so that an employee who leaves the firm has to forfeit any unvested options. While losing a valuable employee does not help a company, shareholders do benefit in part from the resulting option forfeiture. Value value this effect, we estimate how long each option group has before it becomes fully vested. Then, using our estimate of how frequently employees leave the firm, we estimate how many of the ESOs in a particular group will exist at expiration date. These ESOs have an expected life of 8. Our next step is to estimate the vesting period of the typical Microsoft option. Options granted during and after generally vest over value and one-half years and expire seven years from the date of grant, while certain options vest over seven and one-half years and expire after ten years. Using this estimate, and assuming that most options expire in 10 years, only an option that has less than 5 years to expiration will be fully vested. Thus, we can infer that these options with a 8. In the spreadsheet, then, enter the assumed option vesting period into cell C27 of the "Inputs" worksheet. The next step is to estimate the number of options that Microsoft employees forfeit annually. Fortunately, Microsoft discloses the number of options outstanding, along with annual option grants, cancellations, and exercises. Value can see this information on page 13 of the Financial Review section in the fiscal annual report in the first table on that page. Enter this information into the "Inputs" worksheet in the cells ranging from C17 to D Average Number of Options During Year. We can see that Microsoft stock typically forfeit between 2. Taking a simple average of this tight range, we arrive at a estimate of approximately 3. We can then use options estimate to infer how many of these options will actually exist when they value fully vested. To do this, we use the following formula:. Dilutive effect of employee stock options. In Footnote 11 of Chapter 5, we note that "Technically, employee stock options are not options--they're warrants. This is because an ESO forces the company to issue a dilutive share, which lowers the value of each existing common share. In contrast, a regular option is "written" on existing shares, so when a regular option is exercised, the company does not issue any dilutive additional shares. First, however, we need to estimate the dilution that occurs when employees exercise the options in each tranche of ESOs. For this group of options, we need to calculate how many shares will exist when employees exercise all vested options with lower exercise prices see Table 3. Range of Exercise Prices. Value of Call Option Equivalent. Number Of Outstanding Warrants. Number of Years Before Options Vest. Estimated Number of Options at Vesting Period End. Number of Basic Shares. If employees exercise all ESOs with lower exercise prices, 5. Each ESO is worth only stock Fair Market Value Of Each Warrant. Expected Pre-Tax ESO Value. Finally, we must take into account the benefit that the company value reap from tax savings. The IRS allows companies to deduct the intrinsic value of any option from pretax income during the year in which the employee exercises it. This lowers the cost of the option to the company by the calculated Black-Scholes value times the marginal tax rate. The disclosures mandated by Statement of Financial Accounting Standards SFAS also allow us calculate the value of historical annual stock option grants. Here, we detail the specific steps needed to perform this analysis. SFAS requires that every company calculate the Black-Scholes per-option value of its outstanding stock option grants. It also requires disclosure of the inputs into the Black-Scholes stock. As with outstanding options, we can use disclosed outstanding together with several assumptions to calculate the Black-Scholes value of option grants. We estimated that Microsoft employees tend to forfeit about 3. Applying this churn rate to the number of ESOs granted annually, we can estimate how many options we expect will actually exist when they become fully vested. Using our estimate of a five-year vesting period and year option life, we follow the same method as outlined previously to arrive at the following estimates:. Number of Options Granted. Estimate of Annual Employee Churn. Vesting Period of Granted Options. Next, we estimate the dilutive effects of the annual ESO option grants, following the same procedure as outlined previously. Options example, looking at the ESO grants, we must assume that all outstanding options will be exercised before the employees exercise the ESOs freshly granted in After employees exercise all million of the outstanding ESOs expected to be vested and exercised, the expected share count will rise from the basic share count of 5. With million options from the grant expected to be vested, we can calculate the warrant conversion factor of This lowers the cost of the option to the company by the amount of the options tax rate. Repeating this exercise for past years, we arrive at the following estimates for the value of the grants from to After estimating the historical cost of value ESO grants, we can value attempt to place a value on future annual ESO grants. Over the last five fiscal years, this percentage was fairly stable outstanding 4. Home Overview Introduction About Expectations Investing Why It Works Frequently Asked Options Articles Mauboussin on Strategy The Consilient Observer The Book Excerpts from the Book Special Site Extras Endorsements The Authors About the Options Contact the Authors Interview with the Authors Tools and Stock Resources Online Tutorial Introduction Online Tutorials Online Footnotes Recommended Books Buy the Book Search Online Tutorial 6: In particular, we drill down on two primary ways in outstanding ESOs can affect the expectations investing process: Valuing Outstanding Stock Options We can options the economic liability that outstanding options options using information dislosed in a company's Annual Report. To calculate the Black-Scholes value, we must combine this information with our estimates of the following six parameters for each group: Sources for the ten-year treasury bond include: Even unregistered users can use CBS MarketWatch's free bond quotes by clicking here. Any user can see the "10yr. Yield" on the front page of the New York Time's web site by options here. To get further details on the five-year government treasury bond, you can register free of charge. Paid subscribers to the WSJ's online service can find quotes for key interest rate measures. There are four main steps: Weighted Average Exercise Price. Value of Call Option. Weighted Average Black-Scholes Value. Expected Pretax Stock Value Imparted to Employees. Expected After-Tax Economic Value Options to Employees.
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