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As I said at the end of my last post, I wanted to look at ESO's from the perspective of how Chin performed the exercise on PAYX (despite his saying not to follow his lead). Just one question: is it really necessary to carry out the equation to the 30th decimal place? ;)

For 2002, we have 13.169 million shares at an average grant price of \$29.8125 or \$392.6 million worth of options granted (obviously, our figures would be considerably different if we used the "intrinsic value method" cost of the shares).

Reducing that figure by a 10% cancellation rate, we get Carnival receiving \$353.3 million (392.6 x 0.9) when the options are exercised. Using Chin's assumption that share price will grow at the same rate as earnings, I went to MSN Money and found the estimated 5-Year Earnings Growth Rate to be 13.8%, which I used to find out how much a share would be worth 5 years from now:

\$353.3 x 1.138 ^ 5 = \$674.4 million (here's where I cut Chin's 30 decimal places down to 1!).

I hadn't seen that equation before for determining PE ratios, but I slapped it into my formula nonetheless and came up with:

P/E = 8.5 + 2 * 13.8 = 36.1

I then reduced the growth rate after 5 years to the industry norm of 8% and got 8.5 + 2 * 8 = 24.5

We then perform the following calculation (though I'm not sure why):
\$674.4 / 36.1 * 24.5 = \$457.7 million, which we then reduce by the amount employees will have to pay for their options:

\$457.7 - \$353.3 = \$104.4 million

While Chin had PAYX's figure reduced by a tax rate of 35%, I don't do this with Carnival because almost all of its income is exempt from US federal taxes. So we take that \$104.4 million and bring it back to the present:

\$104.4 / 1.138 ^ 5 = \$54.7

That would mean today's expense from granted stock options would equal \$54.7 million. With 2001 earnings equal to \$926.2 million, the current expense is nearly a 6% reduction in income (54.7 / 926.2). Moreover, it translates into a 13.9% reduction in EPS.

However we look at it, it seems while not fatal, Carnival's ESO program could have a significant effect on the company's bottom line, but only if the grants continue at or exceed the 2001 rate. I would imagine that a 0.5% total as witnessed in 2000 would have a negligible effect overall.

Rich

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