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

PREFACE

One of the most striking developments in compensation has been the growth in importance of employee stock option plans. Stock option plans are pervasive among U.S. companies and of increasing importance internationally. Because options exact a significant cost from the existing shareholders and potentially affect managerial decisions, understanding the effects of options is important to understanding and valuing companies. Furthermore, option accounting has proved very controversial. As the incidence of and controversy associated with options has increased, so has the research literature investigating many of the concerns.

The origins of employee stock options reflect the effort to tie compensation to employee performance. Holmstrom (1979) formalized the notion that companies face a fundamental trade-off in compensating risk-averse employees. On the one hand, incentives can be improved by tying compensation to performance and hence aligning employees’ incentives with shareholders’. On the other hand, if employees are risk averse and performance-based compensation places risk on them, the employer will have to provide additional expected compensation for taking on the additional risk.

Option granting began as an executive compensation device because the incentive effects are most clear for individuals who have the ability to significantly affect share price. An increased emphasis on incentive-based compensation along with favorable accounting treatment and other factors ...