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Employee Stock Options, Equity Valuation, and the Valuation of Option Grants Using a Warrant‐Pricing Model
Author(s) -
LI FENG,
WONG M. H. FRANCO
Publication year - 2005
Publication title -
journal of accounting research
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 6.767
H-Index - 141
eISSN - 1475-679X
pISSN - 0021-8456
DOI - 10.1111/j.1475-679x.2005.00164.x
Subject(s) - warrant , valuation (finance) , equity (law) , residual income valuation , stock (firearms) , valuation of options , business , stock options , fair value , shareholder , economics , actuarial science , financial economics , equity risk , finance , corporate governance , mechanical engineering , political science , law , engineering
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.