Incorporating Options and Warrants into Valuation

Options and warrants represent claims on equity value that reduce what common shareholders actually own. Tech companies with heavy stock-based compensation routinely have 10-20% of their equity value committed to option holders—value that doesn't show up in the basic share count. The point is: if you value a company at $10 billion but ignore $1.5 billion in option obligations, you're overpaying by 15% before you even consider growth prospects.

Why Dilution Matters (The Claim on Your Equity)

Every outstanding option, warrant, or convertible security represents a potential claim on the company's equity. When these instruments are exercised, new shares enter the market and dilute existing shareholders.

The mechanics work as follows: A company with 10 million shares trading at $50 has a $500 million market cap. If 2 million options exist with a $30 strike price, those options will eventually be exercised (the holders would pay $30 for something worth $50). When exercised, the share count rises to 12 million—and existing shareholders now own a smaller percentage of the company.

The durable lesson: Basic shares outstanding tell you what exists today. Diluted shares outstanding tell you what you're actually buying into. Professional analysts always use diluted shares when calculating per-share metrics.

The Treasury Stock Method (Standard Practice for Options)

The treasury stock method is the accounting standard for calculating diluted shares. It assumes that proceeds from option exercises are used to repurchase shares at the current market price.

The calculation:

Dilutive Shares = Options Outstanding - (Options x Strike Price / Current Stock Price)

Why this formula works: When an option holder exercises, the company receives cash (strike price x shares). The method assumes the company uses that cash to buy back shares at market price, partially offsetting dilution.

Worked example:

• Current stock price: $50
• Options outstanding: 2 million
• Weighted average strike price: $30

Step 1: Cash received from exercise = 2,000,000 x $30 = $60 million

Step 2: Shares repurchased = $60,000,000 / $50 = 1.2 million shares

Step 3: Net dilution = 2,000,000 - 1,200,000 = 800,000 shares

The treasury stock method adds 800,000 shares to your diluted count, not the full 2 million. This reflects the economic reality that the company receives value when options are exercised.

Why this matters: Using the full 2 million shares would overstate dilution by 150%. But ignoring options entirely understates it by 100%. The treasury stock method captures the actual economic impact.

When Options Are Underwater (And Why You Still Track Them)

Options with strike prices above the current stock price are called "underwater" or "out-of-the-money." The treasury stock method excludes these from diluted share calculations because exercising them would be economically irrational.

A common mistake: treating underwater options as permanently irrelevant. If the stock price rises, those options move into the money and create future dilution. You should track them in your model even if they don't affect current diluted EPS.

The practical approach:

• In-the-money options (strike < stock price): Include in diluted shares using treasury stock method
• Out-of-the-money options (strike > stock price): Exclude from current dilution but note the potential impact in sensitivity analysis

If a company has 1 million options at $60 when the stock trades at $50, those options add zero dilution today. But if your valuation implies a $70 fair value, you need to model those options as dilutive at your target price.

Warrants and Black-Scholes (When Time Value Matters)

Warrants differ from employee options in one critical way: they often trade publicly, giving you a market price for their value. When warrants trade, use the market price directly rather than calculating intrinsic value.

For warrants that don't trade (or for employee options in M&A scenarios), Black-Scholes provides a theoretical value:

Black-Scholes Option Value = S x N(d1) - K x e^(-rt) x N(d2)

Where:

• S = Current stock price
• K = Strike price
• r = Risk-free rate
• t = Time to expiration
• N() = Cumulative normal distribution

When to use Black-Scholes:

1. Valuing private company options for acquisition pricing
2. Estimating stock-based compensation expense
3. Pricing long-dated warrants where time value is significant

The practical point: For most public company valuations, the treasury stock method suffices. Black-Scholes matters primarily when (a) options have 3+ years remaining, (b) you're valuing an acquisition target, or (c) you need to estimate fair value for accounting purposes.

Convertible Debt Treatment (The Two-Part Test)

Convertible bonds give holders the right to exchange debt for equity at a predetermined conversion price. Whether to include conversion in diluted shares depends on comparing the conversion price to your valuation.

The calculation:

Shares from Conversion = Face Value of Converts / Conversion Price

Example: A company has $500 million in convertible bonds with a $40 conversion price. If converted, bondholders receive 12.5 million shares ($500M / $40).

The decision rule:

• Stock price > conversion price: Include converted shares in diluted count (conversion is likely)
• Stock price < conversion price: Exclude from diluted count but note as contingent dilution

The nuance: Unlike options, convertible debt doesn't generate cash proceeds on conversion—the company simply swaps debt for equity. This means convertible dilution hits harder than option dilution. You get no offset from exercise proceeds.

Worked Example: Full Dilution Analysis

Company XYZ setup:

• Basic shares outstanding: 10 million
• Stock price: $50
• Enterprise value from DCF: $600 million
• Net debt: $100 million
• Equity value = $600M - $100M = $500 million

Dilutive securities:

Step 1: Treasury stock method for in-the-money options

Tranche A: 1,000,000 - (1,000,000 x $25 / $50) = 1,000,000 - 500,000 = 500,000 net shares

Tranche B: 500,000 - (500,000 x $35 / $50) = 500,000 - 350,000 = 150,000 net shares

Tranche C: Excluded (underwater)

Total from options: 650,000 shares

Step 2: Convertible debt dilution

$80,000,000 / $40 = 2,000,000 shares

Step 3: Calculate diluted shares

10,000,000 + 650,000 + 2,000,000 = 12,650,000 diluted shares

Step 4: Per-share value

$500,000,000 / 12,650,000 = $39.53 per share

Compare to basic: $500,000,000 / 10,000,000 = $50.00 per share

The impact: Proper dilution adjustment reduces your per-share fair value by 21%. Ignoring dilution would have you paying $50 for something worth $39.53.

Finding Option Data (Where to Look)

Option and warrant data lives in specific sections of public filings:

10-K Annual Report:

• Note on Stock-Based Compensation (typically Note 10-15)
• Weighted average shares calculation (footnote to EPS)
• Outstanding options by strike price range

Proxy Statement (DEF 14A):

• Executive compensation section
• Equity compensation plan information
• Options granted to named executives

The key numbers you need:

1. Total options outstanding
2. Weighted average strike price
3. Weighted average remaining term
4. Options by strike price tranche (for detailed analysis)
5. Convertible debt terms and conversion prices

The practical point: Companies disclose this data because they're required to. The information exists—you just need to find it. The stock-based compensation footnote in the 10-K typically contains everything you need in one place.

Common Errors (And How to Avoid Them)

Error 1: Ignoring underwater options entirely

Underwater options matter for your target price. If your DCF implies $80 per share, options struck at $60 will be in-the-money at your fair value. Run dilution calculations at your target price, not just current price.

Error 2: Using gross instead of net dilution

Adding all options to share count (without treasury stock method adjustment) overstates dilution by 40-60% for typical tech companies. The company receives cash when options are exercised—always account for this offset.

Error 3: Forgetting ongoing grant rates

A company granting 3% of shares annually in new options creates perpetual dilution. Even if you model current options correctly, you'll understate future dilution if you ignore ongoing grants. Add annual grant rate to your projection model.

Error 4: Double-counting stock-based compensation

If you subtract SBC from free cash flow (treating it as a cash expense), you've already captured the dilution cost. You cannot also add diluted shares—that counts the same expense twice. Pick one method: either reduce cash flows by SBC or increase share count for dilution.

Next Steps

1. Pull your largest holding's 10-K and locate the stock-based compensation footnote. Find total options outstanding and weighted average strike price.

2. Calculate net dilution using the treasury stock method at both current price and your target price. Note how dilution changes at higher valuations.

3. Check for convertibles in the debt footnote. Calculate shares from conversion and add to your diluted count if conversion is in-the-money.

4. Compare your diluted per-share value to the market price. If you've been using basic shares, recalculate your entire model with diluted shares.

5. Track the company's annual grant rate over three years. Add this percentage to your forward share count projections.

Related Articles

• Adjusting for Share-Based Compensation and Dilution
• Using Comparable Transactions Data
• Checking Results Against Market-Implied Expectations

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References

Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, 3rd Edition. Wiley Finance. Chapter 16 (Employee Options and Restricted Stock).

Financial Accounting Standards Board. (2004). Statement of Financial Accounting Standards No. 123R: Share-Based Payment. FASB.

CFA Institute. (2020). Equity Asset Valuation, 4th Edition. Wiley. Chapter 7 (Equity Valuation: Applications and Processes), Section on diluted EPS calculation.