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This a bit off the track you and AtlantaDon are on. This idea started out as a random thought when Chinwhisker and the TMF staff started to really address this topic.

Hi Jack,

Thanks for the honorable mention, but I can't claim to be the one getting this started. I searched back through Fooldom and found an article back in 1999 that looked at the expense the same as we do (our friend Elan was looking at this back then as well), much earlier than I even considered ESO expense. In a reply, Bill Mann offered a link to an article that had numerous others included. Check it out;

Over on the FC board, a few of the Fools there got to talking about how they use dilution to adjust their discount rate in the DCFs by the shareholder dilution. I'm not sure if I got the thinking right, or just ad-libbed, but if you look at the granted shares, and divide them by the total number of shares outstanding this will give you a dilution such as the one Tom9 offered. When doing your DCF to find intrinsic value, just simply increase the discount rate to reflect the percentage of dilution for shares. I like this more simple way of looking at the expense.

For example, lets say Gidjo has 450m shares outstanding and grants 9m shares during the period you are looking at. NOPAT, FCF, or normalized earnings would be $22m.

OK, consider this is a steady growing company you expect to grow earnings 15% a year, extremely low debt, and has been around for some 35 years. The discount rate you would apply to this company might be as low as 9%.

You have your numbers for the DCF. Earnings of 22m wouldn't change since you are using shareholder dilution to account for the ESO expense. The growth rate for these earnings wouldn't change since you are not reducing the company's earnings by share dilution, just the shareholder's ownership percentage. The discount rate is a number that we the shareholder, or future shareholder would require for this company to offer you an opportunity to grow your investment 2x/5y or even 10x/5y. This is the amount you would expect your share in the company to grow by. Since the company is diluting your share value by this granting of shares, it is you they are borrowing the money from to pay the execs (Oops I meant employees :o)), so it is you that decides this discount rate. Since they are diluting your ownership at a 2% rate each year, you would want to receive this 2% back in intrinsic value. You increase the discount rate to 11% instead of the 9% you originally required. Without touching the company's numbers, you have just demanded that this company offer a price low enough to make up for the actual 15% CAGR, when what you would now require would be more like 17% CAGR.

Hopefully you haven't fallen out of your chair yet. :o) I still recognize the same expense we always have, the spread between price paid and the price of the share received minus the tax benefit. I also still feel that GAAP should require the actual expense at the time the shares are exercised, the expense the company reports to the IRS, be reported on the income statement, but just don't have any faith in this happening. The use of percentage of dilution to the shareholder being increased on the discount rate will account for the expense as well as trying to determine what the expense going forward from granted options is, and might give an easier guideline for others who haven't studied ESO expense as intensively as we have.

As a side note, if the company actually does recognize some of the expense on the income statement, the percentage should be reduced to reflect this, and some consideration should be given to canceled ESO. When or if the company buys back shares to cover this dilution, we just thank them, and go on, because we realize that buying back these shares, though increasing our ownership in the earnings that could be paid out in dividends or reinvestments has the same effect in reducing earnings that could go out to pay dividends or reinvest in the company.

What you think?

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