Let's remind ourselves of what stock options are. Stock options are contracts offered to employees to purchase company's stock at a fixed price known as the strike or exercise price. After a fixed period, stock options can be diluted to existing shareholders because it enables the option holders to exercise their options and buy stock at a discount to the market price. If the options are in the money. This discount means that the option holders are receiving a proportion of the company's value for free, which dilutes the holdings of existing shareholders. When we are thinking about stock options in valuation, it's helpful to break the effects down into two parts. The effect of options already granted that haven't yet vested, and the effect from future option grants. Let's first think about options which have already been granted but haven't yet vested. These are historic or legacy options, and these will dilute the value of existing shareholders. We already know how we capture the effects of this dilution in our valuation approach. This dilution will be reflected in the diluted share count, which we use when calculating the fully diluted market capitalization and enterprise value. Remember that we calculate this using the treasury method, which takes into account the current share price compared with the average exercise price of the options. So this dilution calculation ensures that our valuation captures the dilution effects of options that are outstanding, or in other words that have already been granted. However, we also need to think about the effective future option grants. Many companies include stock options in employee remuneration packages each year. If a company were to stop granting these options one year, then the employees would likely expect alternative compensation to top up their total comp. So it is reasonable for us to assume that Stock Option grants will usually continue into the future. If the company continues grant options each year and we know granting options is dilutive, then we can anticipate the dilutive effect from future options being granted. So now let's think about how we can capture the dilution from future stock option grants in our valuation. Well, that's going to come from the stock option expense. Remember that the expense represents the options value and therefore dilution, which is being given to employees each year. Therefore, even though we know the stock option expenses are not a cash cost, if we treat them like they are, a cash cost, meaning that we include them in EBIT, EBITDA and free cash flow forecast, we are capturing the dilution which will arise from future stock option grants. This means that when we are calculating our EBIT EBITDA multiples, we include the stock option expense in EBIT and EBITDA, and we are calculating our free cash flows for use in DCF. We include the stock option expense as if it were a real cash flow. A couple of important things to note. Firstly, in case you're thinking well, are you not double counting if you're including both the stock option expense in our earnings and cashflow and the dilution adjustment from stock options in your enterprise value? No. These are two different elements. The dilution calculation captures the dilution from options already granted, and the expense captures the dilution from options that are expected to be granted. We must include both. Secondly, you may see companies excluding stock option expenses in their own adjusted EBIT or EBITDA measures reported in the financials, particularly in the tech sector. Companies typically do this because stock option expenses are non-cash, but this does not mean that you should exclude them from the EBIT or EBITDA that you use for your valuation multiples.
