An employee stock option is a right granted to an employee to purchase a particular number of shares for a fixed price over a defined period of time. Because the price does not change, the employee has effectively been given the ability to share in the company's growth during the life of the option. The New York Times (Apr. 4, 1999, p. BU9) reports that in a recent survey "options accounted for about half the total compensation paid to executives of 428 large companies." In Canada, Investment Executive (September 1998, p. 43) reports that "executives are now getting more than three and a half times their annual salary in option value."

A number of articles that have appeared in the popular press sound an alarm about the proliferation of stock option plans and caution investors about the potentially harmful impact of stock options to companies' future profits and future valuation. This is said to be particularly alarming for NASDAQ stocks, which tend to issue a large number of employee stock options.

Stock options lower worker-related compensation expenses, as instead of paying an employee a high salary, a company offers a lower cash salary plus stock options. An immediate income statement-related expense is lowered, and current income is inflated. The argument then goes that this will inflate stock prices and fool investors, as they do not realize that when these options are exercised, the difference between the stock price and the exercise price will be added to a company's expenses,1 leading to a profit decline. The larger the amount of options granted and the steeper the stock price appreciation, the higher the future profit deflation and stock price decline. To add insult to injury, the exercise of stock options will dilute earnings and existing shareholders' interest, resulting in a further stock price decline. Does this argument hold water?

How is Economic Value Created?
The most popular method used to estimate economic value is the Free Cash Flows (FCF) method, known as the entity approach. The FCF method is founded on the principle that the value of an asset is the present value (PV) of the expected cash flows resulting from the use of the asset over its life.2 For a going concern, the life is assumed to be extended to infinity. The value of the entity as a whole is determined by discounting expected FCFs to infinity. Equity is then estimated by deducting all claims from the entity value.

Exhibit 1 demonstrates this approach. The first two components (value of the company's free cash flows, and the PV of the terminal value) represent the value from operations. But, as companies also have cash flows/assets that are not part of their operating cash flows/assets, the remaining four components have to be added. Once the market value of the company is estimated, an estimate of the market value of common equity (Panel B) is derived by subtracting the market value of all claims against the company's assets, as shown.

The value of the entire company, ignoring for simplicity's sake the non-operating assets referred to in Panel A, is equal to the present value of the company's expected free cash flows from operations to infinity, discounted by the appropriate discount rate.

FCFs do not incorporate any financing-related cash flows such as interest expenses or dividends. In other words, they reflect the cash flows generated by the company that are available to all providers of the company's capital. Stock option holders, by accepting a lower salary, can be considered one of the providers. To be consistent, the discount rate applied to the FCFs should reflect the opportunity cost to all capital providers, including the cost of stock options, adjusted for any tax benefit accruing to the company (i.e., the tax shield provided by the interest expense), and weighted by their relative contribution to the company's total capitalization. This is the definition of the weighted average cost of capital, or WACC (the discount rate applied to FCFs).

Here is where popular interpretations of the effect of stock options get things wrong. Writers conclude that since employees accept a lower salary, and no deduction from revenues is made to reflect the effect of options, net income and FCFs are overstated. True. What is not true, however, is the claim that management has helped ensure the stock price will be higher, by reducing costs.

Current shareholders' equity value per share is what we see quoted in stock markets. Those who will exercise their options in the future are not current shareholders, they are future shareholders. They represent a liability to the current shareholders in the same way as does current debt outstanding. As a result, the PV of their claim has to be deducted from the PV of the FCFs that accrue to all claimholders--which markets know have been over-estimated. It is true that the exercise of these options will weigh down on future earnings for many companies (see footnote 1). But the markets know this. The downward impact has already been incorporated in current stock prices. How this happens is shown in Exhibit 1. When valuing equity, the current value of stock options is deducted from the PV of FCFs that arise from operations. The options can be valued by using one of the popular option valuation models. By subtracting the market value of these stock options, we account for the dilutive effect of these options when exercised in the future.

Media reports are also missing another downward adjustment markets make, as a result of the inclusion of the cost of stock options in the calculation of WACC. This raises the company's cost of capital and reduces the PV of FCFs and current equity value. Since NASDAQ companies grant a large amount of stock options, the discount rate is higher, deflating the PV of (forecasted) FCFs and, hence, current stock price.

Due to the higher discount rate, as well as subtracting the market value of stock options from entity value to determine the market value of current shareholders, the effect of stock options is felt immediately. We do not have to wait until these options are exercised. Employee stock option granting is not worth all the worrying we see in the popular press.

Endnotes
1. This is only true for non-qualified stock options and not for incentive stock options in the U.S. It is never true in Canada.

2. FCFs are defined as earnings before interest and taxes plus depreciation minus increase in working capital and capital expenditures.

Dr. George Athanassakos is a professor of Finance and Director of the financial planning program at the School of Business and Economics, Wilfrid Laurier University in Waterloo, Ont.