Stock Options to Common Shares Ratio
The term stock options to common shares ratio refers to a calculation that allows the investor-analyst to understand the exposure a shareholder has to dilution of their share’s value. Since holders of common stock are entitled to the earnings of a company, stock options pose the risk of diluting the value of shares already held by the public.
Stock Options to Common Shares Ratio = Total Stock Options / Total Common Shares Outstanding
- Total stock options include those granted to employees as well as those vested.
- Total common shares outstanding includes all shares currently issued to the public.
Market performance measures allow the investor-analyst to understand the company’s ability to achieve their high level business profitability objectives. This is usually assessed by examining metrics such as insider transactions, capture ratios, enterprise value, capitalization rates and price to earnings ratios. Market performance metrics provide analysts with a way to determine if a company is going to successfully execute their business plan. One of the ways to determine if a company’s incentive compensation policy poses a risk to existing shareholders is by calculating the company’s stock options to common shares ratio.
When an investor purchases shares of common stock in a company, they become part owners of that business. As such, they are entitled to the profits generated by the company. While it’s typically frowned upon by Wall Street analysts, a company can increase its earnings per share by simply buying back its stock. This is viewed by the market negatively because the company is not increasing earnings per share by increasing its profitability, its merely lowering the number of shares in the denominator of this metric.
The same logic holds true when companies issue stock options to employees as part of an incentive compensation program. If those options vest and are in-the-money, then these new shares serve to dilute the value of existing shares of stock. When companies issue relatively large amounts of stock options to employees, this dilution of value can be significant.
One of the approaches to quantifying this risk is by calculating the company’s stock options to common shares ratio. The metric takes the options issued to employees and divides it by the total number of common shares outstanding. The result of the calculation is the total dilution that can occur. It’s important to understand that not all options will ever be in-the-money and the analyst should take this into account when calculating this ratio.
A mutual fund manager knew Company ABC’s employee compensation program was relatively rich in terms of issuing stock options. He was considering adding Company ABC to his fund, but wanted to understand the risk associated with employees exercising their options and diluting the value of shares held by the fund. He asked his analytical team to examine Company ABC’s proxy statement and determine how many shares had been issued to employees in the form of options, and how many were in-the-money and those likely to eventually be in-the-money. The information below was gathered by his team:
- Total number of shares of common stock outstanding: 108,000,000
- Total number of stock options issued to employees: 12,500,000
- Total number of shares vesting and in-the-money in the next three years: 5,600,000
From this information, the stock options to common shares ratio was determined to be:
= 5,600,000 / 108,000,000, or 5.1%
Given the above information, the mutual fund manager concluded the dilution of shares was minimal and he asked the team to calculation some additional metrics before making a purchase decision.