Stock-based Compensation Expense

The Company recognizes share-based payments to employees as compensation expense using the fair value method. The fair value of stock options and shares purchased pursuant to the ESPP is calculated using the Black-Scholes option pricing model. The fair value of restricted stock and restricted stock units, including PSUs, is based on the intrinsic value on the date of grant. Stock-based compensation, measured at the grant date based on the fair value of the award, is typically recognized as expense ratably over the requisite service period. In 2017 and 2018, the expense recognized over the requisite service period was recorded net of the impact for actual awards that were forfeited prior to vesting in accordance with accounting guidance that became effective in January 1, 2017. Prior to adoption of this guidance, the expense recognized included an estimate of awards that would be forfeited prior to vesting.

The effect of stock-based compensation expense during the three years ended December 31, 2018 was as follows:



	2018		2017		2016
	(in thousands)
Stock-based compensation expense by line item:
Cost of sales	$	4,543	$	2,500	$	2,918
Research and development expenses	203,112		181,900		153,451
Sales, general and administrative expenses	117,392		108,836		84,254
Total stock-based compensation expense included in costs and expenses	$	325,047	$	293,236	$	240,623

The stock-based compensation expense by type of award during the three years ended December 31, 2018 was as follows:



	2018			2017			2016
	(in thousands)
Stock-based compensation expense by type of award:
Stock options	$	107,854		$	105,367		$	114,768
Restricted stock and restricted stock units (including PSUs)	207,845			181,258			118,709
ESPP share issuances	9,933			9,017			7,835
Stock-based compensation expense related to inventories	(585		)	(2,406		)	(689		)
Total stock-based compensation expense included in costs and expenses	$	325,047		$	293,236		$	240,623

The Company capitalizes stock-based compensation expense to inventories, all of which is attributable to employees who support the Company’s manufacturing operations for the Company’s products.

The following table sets forth the Company’s unrecognized stock-based compensation expense as of December 31, 2018, by type of award and the weighted-average period over which that expense is expected to be recognized:



	As of December 31, 2018
	Unrecognized Expense		Weighted-average Recognition Period
	(in thousands)		(in years)
Type of award:
Stock options	$	155,465	2.64
Restricted stock and restricted stock units (including PSUs)	$	321,683	2.58
ESPP share issuances	$	5,132	0.58

Stock Options

The Company issues stock options with service conditions, which are generally the vesting periods of the awards. The Company uses the Black-Scholes option pricing model to estimate the fair value of stock options at the grant date. The Black-Scholes option pricing model uses the option exercise price as well as estimates and assumptions related to the expected price volatility of the Company’s stock, the rate of return on risk-free investments, the expected period during which the options will be outstanding, and the expected dividend yield for the Company’s stock to estimate the fair value of a stock option on the grant date. The options granted during 2018, 2017 and 2016 had a weighted-average grant-date fair value per share of $60.83, $43.27 and $37.93, respectively.

The fair value of each option granted during 2018, 2017 and 2016 was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions:



	2018		2017		2016
Expected stock price volatility	40.50	%	45.31	%	46.77	%
Risk-free interest rate	2.61	%	1.94	%	1.32	%
Expected term of options (in years)	4.55		4.68		4.91
Expected annual dividends	—		—		—

The weighted-average valuation assumptions were determined as follows:


•	Expected stock price volatility: Expected stock price volatility is calculated using the trailing one month average of daily implied volatilities prior to the grant date. Implied volatility is based on options to purchase the Company’s stock with remaining terms of greater than one year that are regularly traded in the market.


•	Risk-free interest rate: The Company bases the risk-free interest rate on the interest rate payable on U.S. Treasury securities in effect at the time of grant for a period that is commensurate with the assumed expected option term.

•

Expected term of options: The expected term of options represents the period of time options are expected to be outstanding. The Company uses historical data to estimate employee exercise and post-vest termination behavior. The Company believes that all groups of employees exhibit similar exercise and post-vest termination behavior and therefore does not stratify employees into multiple groups in determining the expected term of options.


•	Expected annual dividends: The estimate for annual dividends is $0.00 because the Company has not historically paid, and does not intend for the foreseeable future to pay, a dividend.

Restricted Stock, Restricted Stock Units and Performance-based Restricted Stock Units

The Company awards restricted stock and restricted stock units with service conditions, which are generally the vesting periods of the awards. Prior to 2017, the Company also awarded, to certain members of senior management, on an annual basis restricted stock and restricted stock units that vest upon the earlier of the satisfaction of (i) a performance condition or (ii) a service condition.

In February 2016, the Company began granting PSUs to certain members of senior management. Half of the PSUs contain financial goals as the performance metric and the other half contain non-financial goals. A target number of shares was established for each award, however the actual number of shares that are issued when an award vests may range from zero to 200% of the target amount depending upon the level of achievement of the applicable performance metric. The financial-based PSUs vest in three equal installments over a three-year period and are expensed ratably over that same period based upon an assessment of the likely level of achievement. The non-financial based PSUs cliff vest at the end of the three-year performance period and are expensed on a straight-line basis over that same period based upon an assessment of the likely level of achievement.

Employee Stock Purchase Plan

The weighted-average fair value of each purchase right granted during 2018, 2017 and 2016 was $44.04, $35.90 and $26.86, respectively. The following table reflects the weighted-average assumptions used in the Black-Scholes option pricing model for 2018, 2017 and 2016:



	2018		2017		2016
Expected stock price volatility	36.51	%	39.09	%	48.22	%
Risk-free interest rate	2.36	%	1.24	%	0.56	%
Expected term (in years)	0.75		0.75		0.75
Expected annual dividends	—		—		—

The expected stock price volatility for ESPP offerings is based on implied volatility. The Company bases the risk-free interest rate on the interest rate payable on U.S. Treasury securities in effect at the time of grant for a period that is commensurate with the assumed expected term. The expected term represents purchases and purchase periods that take place within the offering period. The expected annual dividends estimate is $0.00 because the Company has not historically paid, and does not for the foreseeable future intend to pay, a dividend.