Warren Buffett in his 1998 Letter to Shareholders:

When we consider investing in an option-issuing company, we make an appropriate downward adjustment to reported earnings, simply subtracting an amount equal to what the company could have realized by publicly selling options of like quantity and structure. Similarly, if we contemplate an acquisition, we include in our evaluation the cost of replacing any option plan. Then, if we make a deal, we promptly take that cost out of hiding.

Paying employees with stock options is an expense that affects the intrinsic value of a firm.  Be sure you are fully accounting for them.  Thankfully in 2004, the Financial Accounting Standards Board (FASB) mandated that the cost of options be reflected in the Income Statement, not buried in the footnotes.  Investor’s however must still be on guard:

1) Unfortunately almost every company still reports their quarterly earnings to the media as excluding the cost of stock-based compensation.  These non-GAAP earnings do not follow the FASB principles.  Do not base your P/E multiples off those earnings.  See this Fortune article for a description of the problem.  This means investors must analyze the Income statement to determine true economic earnings.
2) Use Diluted Shares Outstanding – these account for current in-the-money stock-based compensation (and convertible preferreds) that are outstanding and not yet exercised.
3) Finally, refer to the Notes to Financial Statements to see the Fair Value of remaining unexercised options and other share-based plans (ie. Restricted Stock Units – RSU’s).  Reduce your intrinsic value estimate of the firm by this amount.  Search for the term “unrecognized compensation cost” within the 10-k or annual report to locate.  Add up all values for remaining stock options, RSU’s, etc.  For example, Google has $9.7 Billion (about $14 per share) of “unrecognized compensation”, which are future earnings that will go to employees rather than shareholders.

For some companies this is a gigantic expense.  From the Fortune article:

over the past two decades, Adobe has spent almost $11 billion repurchasing shares, mainly to offset the dilution resulting from the exercise of employee stock options. Despite all the cash that has gone out the door, the share count is not much lower than it was 20 years ago. If you consider that cash as an expense of running the business (offset by the proceeds and the tax benefits from the stock issuance) then Adobe’s free cash flow over the last two decades is not a robust $9.3 billion, but rather a meager $2.3 billion.