Effective 2005, the IASB required employee stock options (ESO) to be expensed in the income statement, with the FASB following a year later. Until then, firms could treat ESO compensation as if it was not a cost, inflating their reported earnings. Consequently, for the era before this accounting change, one must dig up data from the footnotes in order to calculate the cost of ESO issuances and ensure that results are comparable across periods and add the charge to net income so as to arrive at a better measure of NOPAT.
“Employee Stock Option Costs and Goodwill Amortisation, a NOPAT Adjustment”, Joseph Noko
Not only are ESOs a compensation effect that impacts profitability, they are also an obligation to pay employees in shares, in a process of share dilution. There are three ways to value a firm’s ESOs: using company-disclosed fair value, which may be taken at face value if one’s estimate of share price is near that underpinning the option values in the notes to the annual report; option pricing models such as Black-Scholes or more advanced binomial (lattice) models, which, under U.S. GAAP and IFRS, firms use to estimate the total value of all ESOs outstanding; and the exercise value approach, which gives a lower bound for the value of ESOs. In practice, the reported aggregate intrinsic value and the result obtained using Black-Scholes, should be within a narrow range of each other, so I usually elect to use the reported values, unless I see fit to do otherwise. I then subtract this value from my economic book value (EBV) calculation and from the present value of future cash flows in my reverse discounted cash flow (DCF) model.