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

SUMMARY AND APPLICATION

The discussion in this chapter suggests that options represent a substantial obligation for a company because they create a competing claim on the company’s equity. If shares are repurchased to satisfy option exercise, options represent a direct reduction of future cash flows. If shares issued for stock option exercises are not repurchased, existing shareholders suffer dilution of their ownership interest because equity is sold for less than its fair value. In either case, options create a claim against the company that should be considered in equity valuation.

Furthermore, as argued at the beginning of the chapter, a basic approach for incorporating options in equity valuation is not difficult. Perhaps the easiest way to structure the problem is to begin with a basic discounted cash flow analysis and then factor in options explicitly. This approach seems appropriate because past profitability data and earnings forecasts typically exclude the cost of options because options are not expensed under current accounting. Given a discounted cash flow analysis that ignores option costs, options can be explicitly factored in by considering three major components: (1) the obligation for currently outstanding options, (2) the cost of future option grants, and (3) the benefits of option grants.

1. The obligation for currently outstanding options is essentially a liability and is easiest to account for because the options are already outstanding and so less estimation ...