Market valuation of employee stock options

This study investigates whether the value of Employee Stock Option (ESO) can be reasonably estimated and if so whether this value is incorporated in the firm's share price. My results are based on a sample of 478 firms that have granted options to a broad base of employees during the period 1980-1990. I estimate ESO value by modifying an existing option pricing model to take into account some special characteristics of ESO. I find that my estimates for ESO price are consistent with prices set by competitive markets for illiquid securities. I also observe a negative correlation between the value of ESOs and a firm's share price. Further investigation reveals that the negative association is driven by the intrinsic value (stock price minus exercise price) of vested options. In addition, I find no association between the value of ESOs and stock prices of small firms while large firms exhibit a significant negative association. The number of analysts following and percentage of institutional holdings is significantly less in small firms than in large firms. If analysts and institutions are indicators for investors sophistication, then this result is consistent with less sophisticated investors having difficulty interpreting the valuation implications of ESOs under current option disclosure rules. An alternative reason for this absence of association might be that ESOs in small firms generate stronger incentives than ESOs in large firms, causing their benefit in small firms to offset their cost.