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

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  • FENG LI
  • M. H. FRANCO WONG

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

  • Feng Li & M. H. Franco Wong, 2005. "Employee Stock Options, Equity Valuation, and the Valuation of Option Grants Using a Warrant‐Pricing Model," Journal of Accounting Research, Wiley Blackwell, vol. 43(1), pages 97-131, March.
    • Handle: RePEc:bla:joares:v:43:y:2005:i:1:p:97-131
    DOI: 10.1111/j.1475-679x.2005.00164.x
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    Cited by:

    1. Xiao, Wei-Lin & Zhang, Wei-Guo & Zhang, Xili & Zhang, Xiaoli, 2012. "Pricing model for equity warrants in a mixed fractional Brownian environment and its algorithm," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 391(24), pages 6418-6431.
    2. Christian Hofmann & Steven Huddart & Thomas Pfeiffer, 2023. "An analysis of net-outcome contracting with applications to equity-based compensation," Review of Accounting Studies, Springer, vol. 28(3), pages 1657-1689, September.
    3. Yiwei Dou & M. H. Franco Wong & Baohua Xin, 2019. "The Effect of Financial Reporting Quality on Corporate Investment Efficiency: Evidence from the Adoption of SFAS No. 123R," Management Science, INFORMS, vol. 67(5), pages 2249-2266, May.
    4. Ander Olvik & Raul Kangro, 2015. "Pricing of Warrants with Stock Price Dependent Threshold Conditions," Papers 1503.05139, arXiv.org.
    5. Kuo, Chii-Shyan & Yu, Shih-Ti, 2013. "The non-uniform pricing effect of employee stock options using quantile regression," The North American Journal of Economics and Finance, Elsevier, vol. 26(C), pages 400-415.
    6. Andreas Schueler, 2021. "Executive Compensation and Company Valuation," Abacus, Accounting Foundation, University of Sydney, vol. 57(2), pages 297-324, June.

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