Valuation ofEmployee Stock Options

George Montgomery, CFA, FRM

Montgomery Investment Technology, Inc.

Radnor, PA

Phone: 610-688-8111

www.fintools.com

www.fintools.com

Accounting for ESOs

FASB’s stated goal was to improve disclosure of employee stock options: “to level the playing field”

APB 25 only required the Intrinsic Value calculation

FAS 123 “encourages” companies to expense options granted using the Black-Scholes, binomial or other appropriate model

www.fintools.com

FAS 123

Compromise ruling after 11 years of evaluation and debateCompanies do not have to expense option grant valueOnly a footnote disclosure is requiredFlexibility in determining inputs to option pricing model allowed: time to expiration and volatility

www.fintools.com

Standard Option Valuation

Black-Scholes

Modified Black-Scholes

Binomial

Flexible Binomial

CEV

Volatility benchmark from historical prices

Interest rate data from Federal Reserve

www.fintools.com

Non-Standard Options

Barrier (Knock-in, Knock-out)

Average Price (dampens volatility)

Spread (out-performance, index)

Stepped-strike

Some “closed-form” solutions exist

Monte Carlo simulation is often used for more complex contracts

www.fintools.com

Hedging Exposure

Some companies have opted to hedge the exposure that is created when stock options are grantedSome investment banks are willing to take on the riskThe cost of hedging might seem high to some companies: does that mean that the compensation is too high?

www.fintools.com

Current Issues

TransferabilityReissue of options after a drop in stock price (company or market related)More targeted incentive objectivesDo employee stock options achieve the stated goal?Why does Warren Buffett “substitute a cash compensation plan of equivalent economic value”? (Forbes, May 18, 1998)

www.fintools.com

END SLIDESHOW

To go back to FAS123 page:

FAS123