Damodaran on Valuation

Chapter 11. Employee Equity Options and Compensation

In recent years, many firms have shifted toward 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 chapter, 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.