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Chin et.al.,

Pardon me while I try not to spit in the wind or state something obvious.

I have been digesting the ESO issue since Chinwhisker started scratching his beard about several moons ago on the valuations board. I would like to thank all that have provided input it has helped change my thinking about ESO's substantially.

Here is what I'm thinking. Trying to hunt through the finacial statements looking for the hidden costs to earnings of ESO's is not only daunting and time consuming but I think it misses the mark. The price of a given commodity is tied to the number of widgets available and their desirability. Its in this equation that individual investors make thier money, excluding dividends.

I realize that the theory is that price follows earnings. This theory assumes that higher earnings make for a more desirable company. Which would lead one to believe that if we could figure out the cost of ESO's we could deduct that from earnings and get a "real" number to work with.

But desirablity is hard to project into the future. It has too many variables. So wouldn't it be easier to focus on the dilution effect of ESO's?

We can look at a company dilution three ways.

1) We can simply subtract the dilution from our growth projections.
If we excpect the company to grow 20% for five years and 11% for five years and 6% from then on. We adjust, subtract, our projections by the dilution rate. My theory is that if the stock pool is being diluted by 5% each year my share of the earnings is annualy reduced by 5%.

First five years 20%-5%=15% growth
next five years 11%-5%=6% growth
residiual 6%-5%=1% growth

2)To make it easier we could just increase our discount rate. This is based on the theory that the discount rate is the minimum return I'm willing to accept for the risks tied to this company. For the sake of discussion I'll choose 12% because we want to beat the historical return of the market. So we would simply increase our discount to 17% to account for the dilution.

3)We stop playing with the earnings, FCF, EVA numbers entirely and focus on how many shares are going to be there at the end of our DCF calculation. We do that by using a compounding future value formula FV=PV*(1+i/n)^n*m.

or

If we have a company that starts w/ 100 shares outstanding and it is diluting on average by 5% we get a formula that looks like

FV=100(1+.05/10)^10*10 = 164.66
We can simplify the forumula and get near the same number
FV=PV*(1+i)^n
FV=100(1+.05)^10 = 162.88

All of this head scratching theorizing is based on the premis its better to be mostly right than precisely wrong. I'm looking to get into the ball park not the locker room.

Does any of this make sense or am I out lunch.

Please comment.

jack

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