Employee Stock Options, Equity Valuation, and the Valuation of Option Grants Using a Warrant-Pricing Model

We investigate the use of a warrant-pricing approach to incorporate employee stock options (ESOs) into equity valuation and to account for the dilutive effect of ESOs in the valuation of option grants for financial reporting purposes. Our valuation approach accounts for the jointly determined nature of ESO and shareholder values. The empirical results show that our stock price estimate exhibits lower prediction errors and higher explanatory powers for actual share price than does the traditional stock price estimate. We use our valuation approach to assess the implications of dilution on the fair-value estimates of ESO grants. We find that the fair value is overstated by 6% if we ignore the dilutive feature of ESOs. Furthermore, this bias is larger for firms that are heavy users of ESOs, small, and R&D intensive, and for firms that have a broad-based ESO compensation plan. ∗University of Michigan; †University of Chicago. We thank Ray Ball, Dan Bens, Phil Berger, Clement Har, Steve Kaplan, Doron Kliger, S. P. Kothari, Susan Krische, Richard Leftwich, Thomas Lys, James Myers, Dennis Oswald, Joe Piotroski, Doug Skinner, Abbie Smith, K. R. Subramanyam, Shyam V. Sunder, Brett Trueman, Martin Wu, Peter Wysocki, an anonymous referee, and workshop participants at Chicago, MIT, Northwestern, University of Illinois at Urbana-Champaign, and the London Business School 2004 Accounting Symposium for their comments and suggestions. We gratefully acknowledge the financial support of the Graduate School of Business of the University of Chicago and the William Ladany Faculty Research Fund. We also appreciate the contribution of I/B/E/S International Inc. for providing earnings forecast data, available through the International Brokers Estimate System.