Why Is the Expense Treatment of Stock Options So Important?

Employee stock options affect shareholder returns.

Corporations offer employee stock options as compensation. Stock options allow employees to purchase shares of stock at set prices, until the agreements expire after predetermined time periods. Stock option transactions are treated as expenses, because they may cause shareholder value to deteriorate.

Identification

Stocks represent ownership rights that change in value alongside business profitability. The earnings per share statistic divides net income by the amount of shares outstanding, and measures individual shareholder claims to profits. Stock options reduce, or dilute, earnings per share because corporations may issue additional shares to compensate executives.

If the company does not issue additional shares for employee options, the corporation may enter financial markets to buy its own stock. The corporation eventually takes losses, because employees will exercise, or use, options to purchase these shares for beneath-market-value prices.

Features

Employee stock options and their anticipated affect on profits are detailed within corporate income statements, cash flow statements and balance sheets. The cash flow statement presents the amount of corporate cash spent to buy stocks for employees.

Warning

Corporate annual reports may understate stock option expenses. Employee options do not trade on organized financial exchanges and are difficult to value. Complex valuation models, such as Black Scholes, are estimates that reconcile time frame alongside market prices for underlying shares.

References

• Investopedia: Employee Stock Option
• Investopedia: Black Scholes Model
• SEC: Employee Stock Options Plans

Resources

• Investopedia: How to Efficiently Read an Annual Report