The Repricing of Options Effects on Value

In recent years, firms that have seen their stock price drop have often reset their exercise prices on options closer to the market price to make them more attractive to management. This practice is obviously hazardous to stockholders since it increases the value of the option overhang. In face, if this practice is egregious at a firm, you should value the options with an exercise price of zero which would make them each worth as much as a regular share. In effect, the fully diluted estimate of value per share will be the value you get even if you used the option pricing model.

Future Option Grants

While incorporating options that are already outstanding is fairly straightforward, incorporating the effects of future option grants is much more complicated. In this section, the argument for why these option issues affect value is presented and how to incorporate these effects into value.

Why future options issues affect value

Just as options outstanding currently represent potential dilution or cash outflows to existing equity investors, expected option grants in the future will affect value per share by increasing the number of shares outstanding in future periods. The simplest way of thinking about this expected dilution is to consider the terminal value in the discounted cash flow model. As constructed in the last chapter, the terminal value is discounted to the present and divided by the shares outstanding today to arrive at the value per share. However, expected option issues in the future will increase the number of shares outstanding in the terminal year and therefore reduce the portion of the terminal value that belongs to existing equity investors.

Ways of Incorporating Effect into Value per Share

It is much more difficult to incorporate the effect of expected option issues into value than existing options outstanding. This is because you have to forecast not only how many options will be issued by a firm in future periods, but also what the terms of these options will be. While this may be possible for a couple of periods with proprietary information (the firm lets you know how much it plans to issue and at what terms), it will become more difficult in circumstances beyond that point. You will consider a way in which you can obtain an estimate of the option value and look at two ways of dealing with this estimate.

Estimate option value as an operating or capital expense

You can estimate the value of options that will be granted in future periods as a percentage of revenues or operating income. By doing so, you can avoid having to estimate the number and terms of future option issues. Estimation will also become easier since you can draw on the firm's own history (by looking at the value of option grants in previous years as a proportion of firm value) and the experiences of more mature firms in the sector. Generally, as firms become larger, the value of options granted as a percent of revenues should become smaller.

Having estimated the value of expected future option issues, you are left with another choice. You can consider this value each period as an operating expense and compute the operating income, after the expense. You are assuming, then, that option issues form part of annual compensation. Alternatively, you can treat it as a capital expense and amortize it over multiple periods. While the cash flow in the current period is unaffected by this distinction, it has consequences for the return on capital and reinvestment rates that you measure for a firm.

It is important that you do not double count future option issues. The current operating expenses of the firm already include the expenses associated with option exercises in the current period. The operating margins and returns on capital that you might derive by looking at industry averages reflect the effects of option exercise in the current period for the firms in the industry. If the effect on operating income of option exercise in the current period is less than the expected value of new option issues, you have to allow for an additional expense associated with option issues. Conversely, if a disproportionately large number of options were exercised in the last period, you have to reduce the operating expenses to allow for the fact that the expected effect of option issues in future periods will be smaller.

0 0

Post a comment