esops - 1 Employee Stock Options(ESOPs and Restricted Stock...

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1 Employee Stock Options (ESOPs) and Restricted Stock: Valuation Effects and Consequences Aswath Damodaran Stern School of Business September 2005
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2 Management Options and Restricted Stock: Valuation Effects and Consequences In the last decade, firms have increasingly turned to offering employees options and restricted stock (often with restrictions on trading) as part of compensation packages. Some of this trend can be attributed to the entry of young, cash poor technology firms into the market, many of which have to use equity because they have no choice. However, many larger market cap firms that can afford to pay cash compensation have used stock based compensation as a way of aligning managerial interests with stockholder interests. In this paper, we begin by looking at motives, good and bad, for using equity based compensation, and trends over the last few years. We then turn to the accounting rules, old and new, that govern how equity compensation is recorded and reported. Finally, we consider how best to incorporate employee options and restricted stock – both past and prospective – into discounted cash flow and relative valuation models.
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3 In recent years, many firms have shifted towards equity-based compensation for their employees. It is not uncommon for firms to grant millions of options annually not only to top managers but also to lower level employees. These options create a potentially value decreasing overhang over common stock values. What used to be a simple practice of dividing the estimated equity value by the number of shares outstanding to arrive at value per share has become a daunting exercise. Analysts struggle with how best to adjust the number of shares outstanding (and the value per share) for the possibility that there will be more shares outstanding in the future. They attempt to capture this dilution effect by using the partially diluted or fully diluted number of shares outstanding in the company. As we will see in this paper, these approaches often yield misleading estimates of value per share and we propose a sounder way of dealing with employee options. We also explore other forms of equity compensation, including the use of restricted and unrestricted stock grants to management, and the effects of such grants on value per share. Like options, these stock grants reduce the value of equity to existing stockholders and have to be considered in valuation. Equity Based Compensation There are three forms of equity compensation. The oldest and most established one is to give stock or equity in the firm to management, employees or other parties as compensation. This second is a variant, with common stock and equity grants to employees, with the restriction that these shares cannot be claimed and/or traded for a period after the grants. The third is equity options, allowing employees to buy stock in the firm at a specified price over a period; these usually come with restrictions as well. In recent decades, equity-based compensation has become a bigger part of overall
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This note was uploaded on 12/01/2011 for the course FINANCE 350 taught by Professor Aswath during the Summer '10 term at NYU.

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esops - 1 Employee Stock Options(ESOPs and Restricted Stock...

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