Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

EXPECTED COST OF OPTIONS

Conceptually, one way to incorporate existing options when valuing the equity of a company is to include their implications in the forecasted operating cash flow stream. For example, in each future period, the pre-option operating cash flows can be estimated and the cost of satisfying options exercised can be incorporated as part of the cash flow stream.

In practice, however, valuing the option component separately from the other operating cash flows is probably easier because option exercise is difficult to forecast and incorporating option value separately allows one to use existing option-pricing models. In particular, given information on the inputs to an option-pricing model, one can assign a value to the outstanding options and, hence, estimate the magnitude of the obligation.

Before proceeding, however, I will review the accounting and disclosure for stock options, which underpin both the discussion of equity valuation and the review of the research literature.

Accounting for Stock Options

The primary goal of financial accounting is to provide investors with information they can use to value a company’s equity. The challenge for stock option accounting is determining how best to provide the information that investors need to incorporate options properly into equity valuation.

From early on, the Financial Accounting Standards Board (FASB) and its predecessor, the Accounting Principles Board (APB), recognized that options were important to assessing ...