EV to EqV: Valuation of employee stock options

Description
After completing a discounted cash flow (DCF) analysis to value operations, as well as valuing non-operating assets, in order to calculate equity value you need to deduct from the Enterprise value the value of debt, debt equivalents and/ or hybrid claims.


Some of the hybrid claims you fill often find are employee stock options (ESOs), warrants or convertible instruments.


ESOs grants employees the right to buy company stock at a predetermined price (exercise price) for a set period. ESOs are often granted as part of a compensation package and are a way for companies to incentivize and retain talented employees.


Investors should be aware that the value of ESOs can have a significant impact on the equity value of a company. If the company has a large number of outstanding ESOs with a low exercise price, it can dilute the value of existing shareholders' equity.


The Black-Scholes model is a widely used tool for pricing financial derivatives such as options. Another method for valuing ESOs is the binomial model, which involves simulating multiple scenarios and calculating the probability-weighted present value of the ESOs.


It is important to note that valuing ESOs is not an exact science and involves making assumptions about future stock price movements and other variables. As such, it is crucial to consider multiple valuation methods and to exercise caution when relying solely on the results of any one model.


This template applies Black-Scholes valuation method to valuing ESOs, but it can also be used for valuing warrants and the option component of convertible instruments. This template also includes calculation for estimating of the stock volatility based on the historical stock prices, which is an essential input for ESOs valuation.


The Black-Scholes model is based on several key assumptions, it considers the volatility of the underlying stock price, the time until expiration of the option, the exercise price of the option, the current stock price, dividend yield and risk-free rate. By inputting these variables into the Black-Scholes formula, an estimate of the fair value of the option can be calculated.