The costs associated with compiling data on employee stock option portfolios is a substantial obstacle in investigating the impact of stock options on managerial incentives, accounting choice, financing decisions, and the valuation of equity. We present an accurate method of estimating option portfolio value and the sensitivities of option portfolio value to stock price and stock‐return volatility that is easily implemented using data from only the current year’s proxy statement or annual report. This method can be applied to either executive stock option portfolios or to firm‐wide option plans. In broad samples of actual and simulated CEO option portfolios, we show that these proxies capture more than 99% of the variation in option portfolio value and sensitivities. Sensitivity analysis indicates that the degree of bias in these proxies varies with option portfolio characteristics, and is most severe in samples of CEOs with a large proportion of out‐of‐the‐money options. However, the proxies’ explanatory power remains above 95% in all subsamples.

In this paper, we derive a measure of diluted EPS that incorporates the economic implications of the dilutive effects of employee stock options. We show that the existing FASB treasury-stock method of accounting for the dilutive effects of outstanding options systematically understates the options' dilutive effect, and thus overstates reported EPS. Using firm-wide data on 731 employee stock option plans, our proposed measure suggests that economic dilution from options is, on average, 100 percent greater than dilution in reported diluted EPS using the FASB treasury-stock method. We examine the implications of our analysis for stock price valuation, the price-earnings relation, and the return-earnings relation. We demonstrate analytically that when firms have options outstanding, empirical applications of equity valuation models that use reported per-share earnings as an input (e.g., Ohlson 1995) yield upwardly biased estimates of the market value of common stock. We predict that when the difference between our measure of economic dilution from options and the FASB treasury-stock method dilution from options is greater, the observed return-earnings and price-earnings coefficients will be smaller, and we provide some (albeit weak) empirical support for this prediction.