Forbothfirms, theestimatedafter-taxvalueoftheoptions
drops dramatically, leading to an increase in value per share.
Ways of Incorporating Existing Options into Relative Value
Just as options affect intrinsic valuations, they also affect
relativevaluations.Inparticular,comparingmultiplesacross
companiesis complicatedby thefactthat firmsoftenhave
varyingnumbersofemployeeoptionsoutstanding.Afailure
toexplicitly factortheseoptions intoanalysiswillresultin
companieswithunusuallylargeorsmall(relativetothepeer
group)numbersofoptionsoutstandinglookingmisvaluedon
a relative basis.
Toseetheeffectofoptionsonearningsmultiples,consider
the most widely used one, which is the P/E ratio. The
numerator is usually the current price per share and the
denominatorisearningspershare.Analystswhouseprimary
earningsper shareareclearlybiasingtheiranalysistoward
finding companies with higher option overhang to be
undervalued.Toseewhy,notethatthepricepershareshould
incorporate the effect of options outstanding—the market
pricewillbe lowerwhenthere aremoreemployeeoptions
outstanding,butthedenominator(EPS)doesnotchangesince
it reflects actual shares outstanding and does not capture
potentialdilution.Notethatthisbiaswillnotdisappearwhen
firms switch to expensing options.
Tocounterthis,analystsoftenusefullydilutedearningsper
share to incorporatetheeffect ofoutstanding options, thus
penalizing companies with large numbers of options
outstanding.Theproblemwiththisapproachisthatittreats
alloptionsequivalently,withthenumberofsharesincreasing