Mar 07

Employee Stock Options (ESOs). Investor Perspectives: Part 3

by David Harper, CFA, FRM, CIPM

CFA |

In the previous two posts, we summarized the accounting treatment of employee stock options (ESOs) per FAS 123R. We saw that FASB lets companies choose their option pricing model (OPM; e.g., Black-Scholes or binomial) in order to estimate fair value on the grant date (FAS 123R in four words: "grant date fair value"). Although options are awarded in one tranche, their accounting expense is allocated (amortized) over their vesting period (e.g., $300K grant with four year vest: $75K per year). Finally, unless the vesting conditions are market-based (e.g., the option vest if and when the stock's total shareholder return exceeds a benchmark index), the option expense per share is fixed. Only the number of options, as they are forfeited, are reversed in future years. For this reason, we typically say that under FAS 123R, the option expense is generally fixed.

Expense Charge (FAS 123R)

Moving to the investor's perspective, in our screencast, we use a hierarchy (as replicated above). At the bottom are quicker but less accurate methods. The easiest, of course, is to just use the FAS 123R expense. That's the 'as reported' number. But, while FAS 123R is highly congruent with the GAAP Conceptual Framework, it is not necessarily useful to us an analysts. For two reasons:

  • It depends on inputs into the OPMs. In particular, in regard to ESOs, the Black-Scholes is highly dependent on the expected life assumption (because this is used instead of the contractual term, in order to reduce the value of the ESO to account for its lack of liquidity) and the binomial is highly dependent on the Exercise Trigger. Both are also dependent on volatility, and to lesser extents, other inputs.
  • It is fixed so it doesn't account for the true "down the line" dilution profile. Again, a classic example is a high tech company that grants options and incurs a big accounting expense because their stock is volatile. If the stock languishes, the options are not very dilutive but the company is stuck with the expense charge. Accounting expense is different than shareholder dilution.

Diluted EPS

Diluted EPS in an intriguing but incomplete measure of dilution. In regard to ESOs, diluted EPS employs the so-called treasury stock method. The treasury stock method performs one big hypothetical (imaginary) calculation: what if all of the outstanding, in-the-money options were immediately exercised? That would instantly created additional share dilution, but it would also creates cash due to the exercise proceeds (and the cash saved due to a lower tax bill). The net cash benefit is used, as part of this giant imaginary transaction, to repurchase outstanding shares. So this is a clever way of calculating net dilution. A number of shares are added to the denominator of EPS, equal to the number that would be issued upon exercise, minus those that could be repurchased with the cash benefit.

The weakness is that the immediate exercise recognizes all of the intrinsic value and none of the time value of outstanding options. So, while the calculation is very objective (i.e., highly reliable, in accounting parlance) is underestimates dilution by not incorporating time value. For example, underwater (or out-of-the-money) options are excluded altogether.

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