Damodaran on Valuation

11.4. CONCLUSION

The use of equity as employee compensation is not new. Firms have always used equity grants as sweeteners not only to attract managers but also to make them think like stockholders. In the past two decades, the floodgates have opened on equity compensation, especially at technology firms. At many of these firms, managers were rewarded primarily through options, aided by the lax accounting and tax treatment of these grants (by not expensing them until exercise). In the past few years, the awareness of employee options has been raised by two developments. The first is the recognition that some managers were receiving wildly disproportionate rewards for any efforts that they were putting in, with options packages valued in tens of millions of dollars. The second was the belated acceptance by accounting standards boards that employee options are compensation and that they should be valued and expensed at the time of the grant (and not at exercise).

Questions have come with this awareness: How do we value employee options? How do they affect the intrinsic (discounted cash flow) value of a firm? How can we compare multiples of earnings or book value across companies with widely divergent policies on the use of employee options? In this chapter, we have developed answers to these and other questions. In particular, employee option grants affect value per share because they affect current and future earnings and also because they have the potential for altering the number ...