Employee Stock Options, Equity Valuation, and the Valuation of Option Grants Using a Warrant-Pricing Model

This is the pre-peer reviewed version of the following article: Li, F., & Wong, M. F. (2005). Employee Stock Options, Equity Valuation, and the Valuation of Option Grants Using a Warrant‐Pricing Model. Journal of Accounting Research, 43(1), 97-131, which has been published in final form at https://doi.org/10.1111/j.1475-679x.2005.00164.x. This article may be used for non-commercial purposes in accordance with Wiley Terms and Conditions for Use of Self-Archived Versions.We investigate the use of a warrant-pricing approach to incorporate employee stock options (ESOs) into equity valuation and to account for the dilutive effect of ESOs in the valuation of option grants for financial reporting purposes. Our valuation approach accounts for the jointly determined nature of ESO and shareholder values. The empirical results show that our stock price estimate exhibits lower prediction errors and higher explanatory powers for actual share price than does the traditional stock price estimate. We use our valuation approach to assess the implications of dilution on the fair-value estimates of ESO grants. We find that the fair value is overstated by 6% if we ignore the dilutive feature of ESOs. Furthermore, this bias is larger for firms that are heavy users of ESOs, small, and R&D intensive, and for firms that have a broad-based ESO compensation plan.We gratefully acknowledge the financial support of the Graduate School of Business of the University of Chicago and the William Ladany Faculty Research Fund