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Hi Investors. We earlier published an article detailing how dilution affects our ownership position in the company and how it affects the calculations for PE ratio and Earnings Yield ( 1/ PE). In this post, we will cover how employee stock options are converted into common stock and learn how to calculate the incremental contribution to a number of outstanding shares (NOSH) and we will also see How to use Treasury Stock Method to Calculate Diluted Shares.

It’s going to a little lengthier post. However, it will definitely be worth reading if you want to learn the dilution basics. So, let’s get started.

## Why stock options?

Companies are increasingly rewarding their employees using stock options this provides multiple benefits:

1. It helps align the management actions in line with the interests of the shareholders or better said managers of a business become shareholders themselves and are rewarded when their decisions in the operating activities deliver value to the shareholders
2. Employees and managers who are rewarded stock options get the twin benefit of capital appreciation of the stock in the market and also of the lower capital gains tax for investments held over the period of 1 year.

## What are the common terms associated with stock options?

Although there are a lot of terms we may come across when we read about stock options, almost always it will suffice to know just the meaning and relevance of a handful of terms when assessing options. Some of the most relevant that we feel will be useful for our readers are as follows:

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• Issue date: this corresponds to the date on which the underlying stock option was issued to the holder
• Exercise date: represents the date on which the holder of the stock gains the right to exercise the option
• Exercise price: represents the minimum price required to be attained by the shares of the company before the options can be converted into common stocks
• Vested and non-vested shares: When a stock option is owned by an individual and he/she retains the right to exercise them when they wish so, the option is said to be vested. Non-vested shares options, on the other hand, represent those which are still owned by the company and the transfer of ownership to the individual hasn’t occurred yet.
• In-the-money / out-the-money: When the trading price of a stock above the exercise price of the option is then said to be the in-the-money option, while it is said to out-the-money when the share price is below the exercise price (and then rendering the exercising such options useless).

## What are the main kinds of stock options given to employees and management?

In most annual reports investors may come across different types of stock options, the common ones are (but are not limited to) ESOPs or employee stock options, Restricted Stock Units (RSUs), Performance Stock Units (PSUs).

### Employee Stock Options (ESOPs)

In almost all cases these represent the options offered to individuals by companies as a part of their equity compensation plans. These are usually reported by companies with relevant details like issue date, exercise date, and exercise price. The primary catch for the employees here is that their options do not become exercisable unless and until the stock price of the company trades above the mentioned exercise price

These are awards that entitle individuals to ownership rights to a company’s stock. Normally, these are subject to restrictions with regard to the sale of the stock or option until they become vested. The vesting event is determined by minimum service or performance conditions set by the company for the employee. However, during the restricted period, the individuals may have voting rights and the right to the dividends owed to restricted shares.

### Performance Stock Shares (PSSs)

Performance Stock Shares are restricted stock shares that vest upon the achievement of performance conditions specified by the company. These shares are generally subject to sale restrictions and/or risk of forfeiture until a specific performance measurement is satisfied.

Performance measurements are set by your company. During the restricted period you may have voting rights and the right to dividends paid on the restricted shares, which may be paid to you in cash or maybe reinvested in additional performance shares. Once vested, the performance shares are usually no longer subject to restriction.

QUICK READ: What is ESOP Or Employee Stock Ownership Plan?

## What is the treasury stock method and why is it called so?

The most commonly used method within the finance industry to calculate the net additional shares (from exercising the in-the-money options and warrants) is the treasury stock method (TSM).

Here, it is important to note that the TSM makes an assumption that the proceeds the company receives from in-the-money option exercises are subsequently used to repurchase common shares in the market. Repurchasing those shares turns them into shares held in the company’s treasury, hence the eponymous title.

### Implementing the treasury stock method

The broad assumptions in the TSM are as follows. Firstly, it assumes that the options and warrants are exercised at the start of the reporting period and that a company uses the proceeds to purchase common shares at the average market price during the period. This is clearly implied within the TSM formula.

Treasury stock method formula

Additional shares outstanding = Shares from exercise – repurchased shares

### Example

Imagine a scenario where a company has an outstanding total of in-the-money options and warrants for 15,000 shares. Assume that the exercise price of each of these options is around ₹400. The average market price of the stock, however, for the reporting period is ₹550.

Assuming all the options and warrants outstanding are exercised, the company will generate 15,000 x ₹400 = ₹60,000 in proceeds. Using these proceeds, the company can buy ₹6,000,000 / ₹550 = ~10909 shares at the average market price. Thus, the net increase in shares outstanding is 15,000 – 10,909 = 4,091 shares.

This can also be found by simply using the last formula provided above. The net increase in shares outstanding is 15,000 (1 – 400/550) = 4,091.

## Closing thought:  The Good, The Bad and The Ugly

Although options can be a force used for good as described at the beginning of this post it is not always a very innocuous tool. Since almost always, options are more complicated than cash payments there arises a potential for companies to manipulative the rewarding scheme to incentivize the management too much (beyond what is considered acceptable) at the expense of the shareholders.

Another problem can sometimes arise when a firm holds options or convertible debt offerings in another publicly traded company, there have been cases in the stock market history where such firms have gained majority control in the publicly-traded company and subsequently initiated multiple activist campaigns against the management and in extreme cases have ended up owning the company entirely (a lot of the times at the expense of minority shareholders).

An argument that is sometimes overseen but nonetheless is credible when understanding options are that options incentive management to undertake risky decisions. These could sometimes come in the ugly form of management cutting corners to influence the stock prices in the short term so that the options they hold may become exercisable. It is also not uncommon to see situations where management undertakes short-term risks that may eventually outweigh long-term gains for the shareholders.

In view of the above scenarios, a retail investor when assessing companies should look at the state of the options and the rewarding schemes when studying the management of their target company. Normally the two main things an investor needs to look for to be able to make a reasonably informed judgment include the following:

1. The period for the options are awarded: here longer is better, something more than 3 years should be considered as satisfactory
2. The number of options which are awarded: make sure that excessive amounts in addition to the existing cash packages are not paid out to the management and employees unless deserved.

That’s all for this post. I hope it was useful to the readers. Happy Investing.