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

Journal of Accounting Research, Vol. 43, pp. 97-131, March 2005

35 Pages Posted: 8 May 2006

See all articles by M.H. Franco Wong

M.H. Franco Wong

University of Toronto - Rotman School of Management

Multiple version iconThere are 3 versions of this paper

Date Written: 2004-07-11

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 6% if we ignore the dilutive feature of ESOs. Furthermore, 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.

Suggested Citation

Wong, M.H. Franco, Employee Stock Options, Equity Valuation, and the Valuation of Option Grants Using a Warrant-Pricing Model (2004-07-11). Journal of Accounting Research, Vol. 43, pp. 97-131, March 2005, Available at SSRN: https://ssrn.com/abstract=876665 or http://dx.doi.org/10.1111/j.1475-679x.2005.00164.x

M.H. Franco Wong

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

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