Expected Dividend Yield in ESOP Valuation:

Introduction 

Imagine two companies with identical share prices, exercise prices and expected volatility. The only difference is that one company expects to pay higher dividends to its shareholders.

Would their employee stock options have the same fair value?

Generally, no. When employees are not entitled to receive dividends or equivalent benefits before exercising their options, a higher expected dividend yield generally reduces the fair value of a call option. This affects the grant-date fair value used to calculate ESOP compensation expense under Ind AS 102.

Understanding expected dividend yield is therefore essential for accurate ESOP valuation using the Black-Scholes Model.

What is Expected Dividend Yield?

Expected dividend yield represents the dividends a company expects to pay over a year, expressed as a percentage of its share price.

The basic formula is:

Expected Dividend Yield = Expected Annual Dividend per Share ÷ Current Share Price × 100

For example, suppose a company’s share price is ₹200 and it expects to pay an annual dividend of ₹6 per share.

Expected Dividend Yield = ₹6 ÷ ₹200 × 100 = 3%

This means the expected annual dividend represents 3% of the current share price.

For ESOP valuation, the relevant input should reflect expected dividends over the option’s expected life, based on reasonable assumptions at the grant date.

How Does Expected Dividend Yield Affect the Black-Scholes Model?

The Black-Scholes Model uses expected dividend yield as one of its key inputs when valuing options on dividend-paying shares.

For a call option with a continuous dividend yield, the formula is:

C = S₀ e⁻ᵠᵀN(d₁) – Ke⁻ʳᵀ N(d₂)

Here, q represents expected dividend yield, while the other variables represent the share price, exercise price, expected life, risk-free interest rate and volatility.

As expected dividend yield increases, the term representing the present value of the share price decreases. Consequently, the call option’s theoretical fair value generally decreases, assuming all other inputs remain unchanged.

Why Does a Higher Dividend Yield Reduce Option Value?

The reason is straightforward: dividends are paid to shareholders, but an employee holding an unexercised option generally does not receive the dividends paid on the underlying shares.

When a company pays a dividend, its share price typically adjusts downward by an amount related to the dividend, although actual market movements may differ.

An employee who has not yet exercised an option does not receive the dividend and may therefore lose some of the potential benefit associated with the share-price movement.

A higher expected dividend yield generally reduces the anticipated benefit of holding a call option. This is why the Black-Scholes Model incorporates expected dividends into its valuation.

Important exception: If employees are entitled to receive dividends or dividend equivalents on their options before exercise, Ind AS 102 requires the valuation to reflect that entitlement. In the circumstances described in the standard, the option should be valued as if no dividends will be paid on the underlying shares, meaning a zero dividend input is used.

Practical Example: Impact on ESOP Cost

Suppose a company grants 1,000 equity-settled ESOPs to its employees. The current share price, exercise price, expected life, volatility and risk-free rate remain unchanged.

Only the expected dividend yield differs between the two scenarios.

Note: The option fair values are hypothetical figures used to illustrate the relationship. They are not calculated Black-Scholes outputs.

What does this mean?

Under Scenario A, the total compensation cost is ₹80,000. Under Scenario B, it is ₹70,000.

The higher expected dividend yield reduces the illustrative total compensation cost by ₹10,000.

This demonstrates how a change in one valuation assumption can affect the estimated fair value of an ESOP and, consequently, the employee compensation expense recognised by the company.

How Does Expected Dividend Yield Affect ESOP Expense Under Ind AS 102?

For a typical equity-settled ESOP, the grant-date fair value is recognised as employee compensation expense over the applicable vesting period as employees render the required services.

Assume the options in Scenario A vest over four years and straight-line recognition is appropriate.

Annual compensation expense = ₹80,000 ÷ 4 = ₹20,000.

For Scenario B:

Annual compensation expense = ₹70,000 ÷ 4 = ₹17,500.

The difference in annual expense is ₹2,500.

The typical annual journal entry for Scenario A would be:

Employee Compensation Expense A/c Dr. ₹20,000

To ESOP Outstanding Reserve A/c ₹20,000

For Scenario B, the corresponding annual entry would be ₹17,500, subject to the applicable accounting requirements and actual vesting conditions.

Thus, a lower expected dividend yield can lead to a higher option fair value and higher compensation expense, while a higher expected dividend yield can lead to a lower option fair value and lower compensation expense.

How Should Companies Estimate Expected Dividend Yield?

Companies should use reasonable, supportable assumptions when estimating expected dividends for ESOP valuation.

Relevant considerations include:

• Historical dividend patterns: Examine past dividend payments and changes in dividend policy.
• Current dividend policy: Consider publicly available information about the company’s intended distributions.
• Future dividend expectations: Assess whether dividends are expected to continue, increase, decrease or begin during the option’s expected life.
• Comparable companies: For an emerging company without a dividend history, an appropriate peer-group dividend yield may help inform the estimate if the company expects to begin paying dividends.
• Employee dividend entitlements: Determine whether employees receive dividends or equivalent benefits before exercising their options.

 Conclusion

Expected dividend yield is an important input in the Black-Scholes Model because it influences the theoretical fair value of employee stock options.

When option holders are not entitled to dividends before exercise, a higher expected dividend yield generally reduces call option fair value. This can lower the total compensation cost recognised under Ind AS 102 for equity-settled ESOPs.

However, the dividend assumption should not be selected merely to achieve a lower accounting expense. It must reflect the company’s expected dividend policy and the employee’s actual rights under the ESOP arrangement.