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Summary

The existence of options and the possibility of future option grants makes getting from equity value to value per share a complicated exercise. To deal with options outstanding at the time of the valuation, there are four approaches.

The simplest is to estimate the value per share by dividing the value of equity by the fully diluted number of shares out-standing. This approach ignores both the expected proceeds from exercising the options and the time value of the options.

The second approach of forecasting expected option exer-cises in the future and estimating the effect on value per share is not only tedious but unlikely to work.

In the treasury stock approach, you add the expected pro-ceeds from option exercise to the value of equity and then divide by the fully diluted number of shares outstanding. While this approach does consider the expected proceeds from exer-cise, it still ignores the option time premium.

In the final and preferred approach, you value the options by using an option pricing model and subtract the value from the value of equity. The resulting estimate is divided by the primary shares outstanding to arrive at the value of equity per share.

Usually, the current price of the stock is used in option pricing models, but the value per share estimated from the dis-counted cash flow valuation can be substituted to arrive at a more consistent estimate. To deal with expected option grants in the future, you must dissect the current operating income to consider the effect that option exercises in the current period had on operating expenses. If the options granted dur-ing the period had more value than the option expense result-ing from exercise of options granted in prior periods, the current operating income has to be adjusted down to reflect the difference. Industry-average margins and returns on capi-tal will also have to be adjusted for the same reason.

Once the value per share of equity has been estimated, that value may need to be adjusted for differences in voting rights. Shares with disproportionately high voting rights will sell at a premium relative to shares with low or no voting rights. The difference will be larger for firms that are badly managed and smaller for well-managed firms. When valuing a private firm, you may also need to discount the estimated value of equity to reflect the lack of liquidity in the shares. In fact, even publicly traded firms can face a discount if the shares that are traded are illiquid.

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