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

IMPACT ON CASH FLOW AND VALUATION

The preceding sections discuss research on basic issues in valuing equity for companies with employee stock options. In this section, I consider research on a variety of other topics with implications for equity valuation.

Determinants of Option Grants

One of the difficulties in incorporating future option grants into equity valuation is estimating expected option intensity. At the start of this chapter, I estimated the effect of future options separately from operating cash flows, reflecting an assumption that the starting point was operating cash flows, excluding options—a reasonable assumption if the starting point for the cash flow forecast is reported earnings, ignoring options. An alternative approach, however, is to subtract expected option expense from each year’s net income and explicitly forecast profitability after the effect of options. Because the future value of options is being present-valued under both approaches, they should yield similar answers. Assuming that the FASB and IASB ultimately require stock option expensing (and analysts forecast reported net income), future option grants will be incorporated more naturally in equity valuation.

Even if options are expensed, however, future option grants will still need to be estimated in arriving at earnings forecasts. One way to incorporate options would be to forecast total compensation under the assumption that the components of compensation are less important than the whole. But ...