Mar 08

Employee Stock Options (ESOs). Investor Perspectives: Part 4

by David Harper, CFA, FRM, CIPM

CFA |

Previously, we summarized the accounting treatment of ESOs and the two easy ways to estimate dilution: use the 'as reported' accounting expense (FAS 123R) or the diluted earnings per share (diluted EPS, per FAS 128). We continue here by highlighting concepts from our one-hour screencast tutorial on ESO Dilution from the Investor's Perspective. We've said the choices available to the investor, as he/she analyzes ESO dilution, runs the ladder from easy (FAS 123R charge) to difficult (net cash flow).

Incorporated or Standalone (a la carte)

The approaches also divide into two types: incorporated or standalone. Incorporated methods take the dilutive impact of ESOs and "build in" their impact in to create an adjusted net income, EPS, or net cash flow. In other words, the company's bottom line is adjusted to handle the cost of ESOs. This approach includes expense charge (per FAS 123R), diluted EPS, and net cash flow.

The other approach is to estimate dilution alongside the financials. This simply means we calculate an ESO dilution metric and analyze it among a set of other factors. This is an a la carte approach. We already do this with other metrics like days sales outstanding (DSO), gross margin or credit rating. In the case of a credit rating, unless we are employing a sophisticated (structural or Merton-type) model, typically we look at the credit rating of a company (e.g., BB+) as one metric among a buffet of metrics. In an a la carte approach, we commonly evaluate a metric and say "this falls into the green/yellow/red zone."

In regard to ESOs, the two a la carte approaches are potential dilution (a.k.a., equity overhang) and economic dilution.

Lifecycle of an ESO

In the screencast, we look at the lifecycle of an ESO. This helps to understand the difference between flow measures (like run-rate or burn-rate) and stock measures (like overhang).

Flow and stock are building block concepts. Flow dilution, like water under the bridge, captures periodic dilution (how much dilution during the fiscal year?). It goes with the flow-ish income statement. Stock balances dilution exposure at a single point in time; it reflects instantaneous dilution exposure (what's our exposure, right now?). It goes with the stock-ish balance sheet.

In the lifecycle diagram above, note four stages:

  1. At the beginning of they year, the company has number of shares/options, in an authorized incentive pool, that are "available for future grant."
  2. During the year, the company will issue or grant shares/options (the company may also authorize additional shares for the pool). Options granted during the year, as a percent of CSO, is called run-rate or burn-rate.
  3. At the end of the year, a new number of shares/options will be available. This will equal to the starting number (as of Jan 1) minus (-) shares/options awarded plus (+) additional authorizations. (Cancellations may impact the pool, too).
  4. If, at the end of the year, we add the number of shares/option available for future grant plus (+) the shares/options that are already outstanding (i.e., held by employees), we get the sum called equity overhang or potential dilution

Potential Dilution (equity overhang)

Potential dilution is calculated as a percentage of common shares outstanding (% of CSO). So, if a company has 100 million CSO, 10 million options outstanding (held by employees: issued but unexercised) and 5 million options in the incentive pool (available but unissued), then the potential dilution is 10% outstanding (10/100) plus 5% (5/100) equals 15%. Technically, it is correct to include the dilutive shares in the denominator, so a better calculation is: 15/115 = 13.04%. Both are used, it's more important to be consistent year-to-year and peer-to-peer.

Because this is an a la carte approach, we typically compare this to (i) the company's own history and (ii) the company's peer group. I like to say "peers and years"- the basis for all comparisons! So, for example, 13% would be low for a technology company and near the middle for a manufacturer.

This approach, potential dilution, was commonplace ten years ago. Some consultancies continue to rely on it. But it's lost some power as companies diversify away from standard-issue stock options. If everybody grants the same plain vanilla options (issued at FMV, 10 year term, four year vest), then numerically-based comparisons work pretty well. But nowadays, some issue options, some restricted stock, some performance-based stock, and increasingly, a blend of each. The weakness of overhang is that it gives the same respect to all award types: 1 option = 1 restricted share = 1 performance-based share. But they aren't equal economically.

Economic Dilution (replace # with $)

Economic dilution takes the numerically-based overhang and replaces the numbers values ($ instead of #). In doing so, I like to say it's a "poor man's institutional metric." That's because, if you want to see how ESO cost should really be measured, you need to examine how it's done by Institutional Shareholder Services (ISS). For a long time, ISS has employed a metric called shareholder value transfer (SVT) that is a theoretically proper economic valuation. In their case, it 's the equity overhang ration but with values. In the numerator, a binomially-based value estimate of (i) shares authorized in the pool + (ii) shares outstanding + (iii) any pending authorizations before shareholders. In the denominator, numerically-based CSO is replaced with equity market capitalization (plus everything in the numerator, for a "diluted" calculation).

Why is this elegant and accurate? Because different instruments are adjusted for the dilutive impact. A single restricted share will count more than a single stock option (which are equal in overhang), an out-of-money option will count less than an in-the-money option.

Stock and Flow recap

Finally, just a reminder: we didn't discuss run-rate or burn-rate. That's the 'flow' metric: awards granted during the period, as a percentage of CSO. Compare this flow metric to the stock metrics above, potential and economic dilution. These measure point-in-time dilution (e.g., at the end of the year). So, we call them exposure measures.

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