📚 PASS Research Analyst Certification Examination Difficulty: Beginner ℹ️ Info   ~5 min read
📌 Chapter 2.3 — Structure of Securities Market

You are deep into your quarterly earnings analysis for a fast-growing IT services company, fine-tuning your discounted cash flow model. As you reconcile the company’s financial statements, you notice a discrepancy between the ‘Basic’ and ‘Diluted’ Earnings Per Share (EPS) figures in the notes to accounts. This variance is not merely an accounting quirk; it is a direct result of Employee Stock Option Plans (ESOPs) currently sitting in the company’s treasury.

As a Research Analyst, your job is to determine whether these potential shares represent a genuine threat to shareholder value or a standard incentive mechanism.

When a company grants options to employees, it creates a future obligation to issue equity. While these options are ‘out-of-the-money’ or unvested today, they act as a latent claim on future earnings. From a valuation perspective, you must compute the diluted EPS to account for the total number of shares that would be outstanding if all dilutive potential common shares were exercised. Failing to incorporate this in your projection models would artificially inflate your target price, leading to an overvaluation that could mislead your institutional clients.

Consider a scenario where Company X reports a net profit of ₹100 crore with 10 crore shares outstanding, resulting in a basic EPS of ₹10. However, if the company has 1 crore outstanding employee options exercisable at a price significantly below the current market rate, the ’treasury stock method’1 suggests that the dilutive impact must be adjusted. By ignoring this, you are effectively assuming that the current equity base remains static, ignoring the reality of equity compensation.

A seasoned analyst always models the ‘as-if’ scenario to ensure that the cost of incentivizing talent is fully captured within the firm’s cost-of-capital framework.

Ultimately, your recommendation hinges on the quality of your earnings forecast. If a management team uses excessive ESOP grants, they are essentially printing currency that dilutes existing shareholders’ ownership percentages. By scrutinizing the ‘weighted average number of shares’ in the denominator of your EPS calculations, you gain a clearer picture of the management’s capital allocation integrity. Always distinguish between performance-linked ESOPs, which align employee interests with yours, and blanket grants that prioritize staff compensation at the expense of shareholder equity.

Nuance

⚠️ Nuance
Many candidates confuse the mere presence of ESOPs with immediate dilution; however, dilution only impacts EPS once the options are ‘in-the-money’ and accounted for in the diluted EPS calculation. The common pitfall is ignoring the treasury stock method, which prevents double-counting by assuming the company uses the exercise proceeds to offset the dilution. Always check if the company uses the ‘weighted average’ number of shares to account for the timing of option grants throughout the fiscal year.

Check Your Understanding

Practice Question 1

A firm has 1,000,000 shares outstanding and an additional 100,000 options exercisable at ₹50. The current average market price is ₹100. Using the treasury stock method, how many incremental shares are added to the denominator for diluted EPS?

Practice Question 2

Why must an analyst specifically examine the difference between Basic and Diluted EPS when evaluating a company with aggressive ESOP policies?

This is a companion read for Section 2.3 — Structure of Securities Market from PASS Research Analyst Certification Examination by Akhilesh Gururani, available on Amazon Kindle.

Copyright © 2026 Akhilesh Gururani. All rights reserved.

  1. The Treasury Stock Method assumes that the proceeds from the exercise of employee stock options are used by the company to repurchase its own shares at the average market price during the period. ↩︎