Employee Stock Options, Equity Valuation, and the Valuation of Option Grants Using a Warrant-Pricing Model

Posted: 31 Mar 2005

See all articles by M.H. Franco Wong

M.H. Franco Wong

University of Toronto - Rotman School of Management

Feng Li

Shanghai Advanced Institute of Finance, Shanghai Jiaotong University

Multiple version iconThere are 3 versions of this paper

Abstract

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 six percent if we ignore the dilutive feature of ESOs. Further, 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.

JEL Classification: G12, G13, M41, J33

Suggested Citation

Wong, M.H. Franco and Li, Feng, Employee Stock Options, Equity Valuation, and the Valuation of Option Grants Using a Warrant-Pricing Model. Journal of Accounting Research, Vol. 43, No. 1, pp. 97-131, March 2005. Available at SSRN: https://ssrn.com/abstract=680692

M.H. Franco Wong (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6
Canada
416-946-0729 (Phone)

HOME PAGE: http://www.rotman.utoronto.ca/FacultyAndResearch/Faculty/FacultyBios/Wong.aspx

Feng Li

Shanghai Advanced Institute of Finance, Shanghai Jiaotong University ( email )

211 West Huaihai Road
Shanghai, Shanghai 200030
China

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