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

OPTION VALUE TO EMPLOYEES

As noted earlier, an important result of providing options is that many employees end up with poorly diversified portfolios, which means that they are exposed to a good deal more risk than they would like. Left to their own devices, risk-averse employees with substantial option compensation would probably prefer to lay off that risk by selling or hedging some or all of their options. Typically, however, employees are not given the opportunity to sell their options and are prohibited from hedging with tactics such as shorting the employer’s stock. As a result, the choice is between holding a risky investment and sacrificing the investment’s upside potential by exercising the options early.

Employee Risk Aversion vs. Incentive Effects

The inability to lay off risk is crucial because it is the risk that creates the incentive effects. If employees were permitted to sell their options, the option’s value to employees would increase, but the incentive value for the company would be lost because once the options were sold, the employees would have no stake in the company’s share price performance. Hedging has a similar effect. If employees could short the stock, the incentive properties would be sacrificed because the share price exposure would be gone.

This wedge between the theoretical value of options and their perceived value to employees represents a sort of deadweight loss, potentially made up by the incentive effects of options. To the extent that the ...