As an employee benefit or incentive, many companies grant stock options to certain employees. Essentially, employee stock options give you the right to purchase a certain amount of stock at a pre-determined price, during a specific period of time. Here's how to estimate the potential value of your employee stock options as your company's stock price grows.
How employee stock options work
In a nutshell, employee stock options allow you to purchase a certain number of shares of the company's stock, at a pre-determined price, for a certain period of time. For example, an employee stock option grant may allow you to buy 1,000 shares of stock for $50 per share anytime within the next two years. The price the option allows you to buy shares for is known as the exercise price, or strike price.
Generally, you have to wait a certain period of time before you can exercise the option, known as the vesting period. Options may vest over time -- for example, of a 1,000-share option grant, 250 shares may vest after one year, another 250 after the second year, and so on.
The idea with employee stock options is to give employees the ability (or the possibility) to purchase shares of the company's stock at a discounted price to market value. In theory, employee stock option awards are designed to not only encourage the employee to remain with the company through the end of the vesting period, but are also intended to be a motivational tool, as the employee will now directly benefit from the company's performance.
Future value of your employee stock options
The future value of your employee stock options will depend on two factors: the performance of the underlying stock and the strike price of your options. For example, if the stock is worth $30 and your option's strike price is $25, your options will be worth $5 per share.
With that in mind, here's a calculator that can help you determine the potential value of your stock options, based on hypothetical returns.
Editor's note: The following paragraph is provided by CalcXML, which built the calculator below.
As an example, let's say that you have the option to buy 500 shares of your company's stock for $20 at any time within the next five years. You company's stock currently trades for $18, and you anticipate the share price will rise by 8% per year. According to the calculator, at the end of five years, 500 shares of stock will be worth $13,224. Subtracting the $10,000 it would cost to exercise the options shows a pre-tax gain of $3,224.
The calculator also evaluates a low-return scenario (6% annually), which would produce a gain of $2,044, and a high-return scenario (10% annually), which would produce a $4,495 gain.
Of course, the actual value of your stock options depends on the actual performance of the stock during the time period prior to expiration. However, based on expected rates of return, this calculator can help you determine the potential value of your options at expiration.
The tax treatment of employee stock options depends on whether they're classified as non-qualified stock options (NSOs) or incentive stock options (ISOs).
With both types of options, the grant of the options is not a taxable event. The major difference is that with non-qualified stock options, taxation of the "bargain element" -- that is, the difference between the stock's market price and the exercise price -- begins at the time of exercise. Any further gain can be taxed when the shares are eventually sold. On the other hand, with incentive stock options, taxation doesn't occur until the shares are sold.
In either case, if the shares are held for less than 12 months, any gain is considered a short-term gain and is taxable as ordinary income, while shares held for longer than 12 months are taxable at more favorable long-term capital gains rates.
The Motley Fool has a disclosure policy.