Stock Options and Their Impact on Diluted EPS
Stock options are a form of equity-based compensation granted by
companies to employees, executives, or other stakeholders, allowing them to
purchase company stock at a set price (known as the exercise price or
strike price) within a certain period. Stock options are a type of dilutive
security, meaning that when exercised, they increase the number of
outstanding shares, which can reduce Earnings Per Share (EPS).
Key Concepts:
1. Employee Stock Options:
o These are options granted to employees that give them the right
to buy the company's stock at a pre-determined price.
o They typically vest over a period of time (for example, after a
certain number of years or based on performance).
o The main idea is to incentivize employees to contribute to the
company’s success by aligning their interests with those of
shareholders. As the company's stock price rises, employees
stand to benefit by exercising their options at a lower price.
2. Stock Option Exercise:
o When an option holder exercises their options, they purchase
shares at the exercise price.
o If the exercise price is lower than the current market price, the
holder can profit from the difference between the market price
and the exercise price.
o For example, if an employee has an option to buy stock at $10
and the market price is $20, they can buy the stock at $10 and
immediately sell it at $20, making a profit of $10 per share.
Impact on Diluted EPS:
When calculating Diluted EPS, stock options are included in the weighted
average shares outstanding because they have the potential to increase
the number of shares in circulation. This leads to a dilution of earnings,
which results in a lower Diluted EPS than Basic EPS.
The inclusion of stock options in the EPS calculation follows the Treasury
Stock Method (TSM), which estimates the number of shares that could be
repurchased with the proceeds from the exercise of the options.
Treasury Stock Method (TSM) for Stock Options:
The Treasury Stock Method is used to calculate the potential impact of
stock options on Diluted EPS. The method assumes that the proceeds from
the exercise of stock options (i.e., the money that the company receives
when the options are exercised) are used to repurchase shares at the current
market price. The net increase in shares is added to the weighted average
shares outstanding.
Steps for calculating the impact of stock options:
1. Calculate the number of shares that would be issued upon
exercise: This is the total number of options that are exercisable
during the period.
2. Calculate the proceeds from the exercise of options: This is the
number of options multiplied by the exercise price.
3. Calculate how many shares could be repurchased with the
proceeds: This is the amount of proceeds divided by the current
market price of the stock.
4. Net increase in shares: The difference between the number of
shares issued upon exercise and the number of shares that could be
repurchased.
Example:
Assume a company has:
Net Income: $1,000,000
Preferred Dividends: $100,000
Basic Shares Outstanding: 1,000,000 shares
Stock Options Outstanding: 200,000 options with an exercise price
of $10
Current Stock Price: $20
1. Proceeds from exercising options:
Proceeds=200,000 options×10 (exercise price)=2,000,000 dollars\
text{Proceeds} = 200,000 \text{ options} \times 10 \text{ (exercise price)}
= 2,000,000 \text{ dollars}
2. Number of shares repurchased:
Repurchased shares=2,000,00020=100,000 shares\text{Repurchased
shares} = \frac{2,000,000}{20} = 100,000 \text{ shares}
3. Net increase in shares:
Net increase in shares=200,000−100,000=100,000 shares\text{Net increase
in shares} = 200,000 - 100,000 = 100,000 \text{ shares}
4. New diluted shares outstanding:
Diluted Shares Outstanding=1,000,000+100,000=1,100,000 shares\
text{Diluted Shares Outstanding} = 1,000,000 + 100,000 = 1,100,000 \
text{ shares}
5. Diluted EPS:
Diluted EPS=1,000,000−100,0001,100,000=900,0001,100,000=0.818 per sh
are\text{Diluted EPS} = \frac{1,000,000 - 100,000}{1,100,000} = \
frac{900,000}{1,100,000} = 0.818 \text{ per share}
As shown, the Diluted EPS is lower than the Basic EPS because the
potential exercise of stock options increases the number of shares
outstanding, leading to a dilution of earnings.
Importance of Stock Options in Diluted EPS Calculation:
1. Potential Dilution: Stock options are a form of potential dilution.
Even if the options are not exercised yet, they represent the possibility
that additional shares could be issued, reducing the value of existing
shares and diluting EPS.
2. Investor Insight: Including stock options in the Diluted EPS
calculation gives investors a more accurate picture of a company's
earnings, considering the likelihood of future dilution. This can help in
evaluating how the exercise of options or other convertible securities
might affect their stake in the company.
3. Stock Option Plans: Companies often use stock options as a form of
compensation to retain and motivate employees. However, investors
need to consider how widespread stock option grants might affect their
holdings, particularly in high-growth companies where stock options
are frequently exercised.
Conclusion:
Stock options play a significant role in Diluted EPS calculations because
they can increase the total number of shares outstanding, leading to
potential dilution of earnings. By using the Treasury Stock Method,
companies can estimate the effect of options on earnings per share and
present a more conservative view of profitability. For investors,
understanding how stock options affect Diluted EPS provides a clearer view
of potential future dilution and its impact on shareholder value.
