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What Are Stock Options for Employees? - Value & Concept

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  • 0:00 What Are Stock Options?
  • 1:37 Why Stock Options?
  • 2:50 Value of Stock Options
  • 4:04 Risks and Benefits
  • 5:44 Lesson Summary
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Lesson Transcript
Instructor: Andrea Rea

Andrea is a practicing attorney and MBA with 15 years experience in health care administration, litigation and business law.

There are many forms of employee compensation other than just a paycheck. Learn about employee stock options as a common form of incentive pay, including how to calculate the value and identify risks and benefits.

What Are Stock Options?

You've worked hard in school. Now as a result of your perseverance and good grades, you've landed several job interviews with prestigious companies. When reviewing their offers, you notice that some companies boast a generous compensation package, including eligibility for stock options. Should you be excited? First, you need to know what a stock option is and how much it is worth.

A stock option is an agreement between an employer and employee that allows an employee to buy a fixed number of shares of company stock at a specific price, usually within a set period of time. The employee stock option agreement spells out all the details, including the rules that apply to the option plan.

Another important term to know is grant price (also called the strike price or exercise price). This is the price at which the employee will be able to purchase the stock. Typically, employees must wait a specified period before being allowed to exercise the option. At this point, the stock option is vested, which means the wait period has passed. After the vesting period, employees may elect to exercise the option. At that point, the employer is obligated to sell the employee company stock at the grant price. The employee can then sell the stock and collect the proceeds or hold onto it in the hope the price goes up further. If the employee chooses not to exercise the option during the time allowed, it will lapse. Unexercised stock options have no value after they lapse.

Why Stock Options?

We now know about stock options, but why do employers offer them? Well, stock option plans can be an attractive way for companies to share ownership with employees, reward them for good performance, and increase motivation. Stock options represent an ownership interest in the company and so they are often used as a form of incentive pay. Pay incentives are amounts in addition to base compensation designed to reward employees for good performance. Pay incentive programs include bonuses and profit sharing, which are also known as variable pay.

As of 2014, 8.5 million employees in the U.S. hold stock options, according to the independent research organization, NORC, at the University of Chicago. In the past, stock options were mainly given only to top executives. Now, large, publicly traded companies, such as Starbucks, Southwest Airlines, and Cisco, give stock options to most or all of their employees. More than ever before, it's important for employees to understand stock options, including the basics of how to value them in order to determine how much they are really getting.

Value of Stock Options

Publicly held companies generally offer stock options to employees at the current trading price on the day the options are granted. If the market price of the stock goes up in the future, employees can exercise their stock options and collect the difference between the grant price and the current market price.

Now, let's look at how to calculate the value of an unexercised stock option. It's pretty simple. Start with the current market price of the stock, then subtract the grant price. Lastly, multiply that difference by the number of shares for which the option can be exercised. The number you get is called the intrinsic value, or the amount of profit that could be made if you were to exercise the stock option. Let's look at an example to better understand this.

Two years ago, Joan was granted a 10-year stock option to purchase 1000 shares of her employer's stock at a price of $25 per share (which is the grant price). The market value of the stock today is $50 per share. Now, we plug these numbers into our formula, which gives us our new equation: V = (MP - GP) * S, or V = (50 - 25) x 1000.

When we solve, we get our intrinsic value, $25,000.

Price to Earnings Ratios
S&P 500 price to earnings ratio

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