Valuation of Employee Stock Options

1
Valuation ofEmployee Stock Options

• George Montgomery, CFA, FRM
• Montgomery Investment Technology, Inc.
• Radnor, PA
• Phone [phone]
• www.fintools.com

2
Accounting for ESOs

• FASBs 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

3
FAS 123

• Compromise ruling after 11 years of evaluation
  and debate
• Companies do not have to expense option grant
  value
• Only a footnote disclosure is required
• Flexibility in determining inputs to option
  pricing model allowed time to expiration and
  volatility

4
Standard Option Valuation

• Black-Scholes
• Modified Black-Scholes
• Binomial
• Flexible Binomial
• CEV
• Volatility benchmark from historical prices
• Interest rate data from Federal Reserve

5
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

6
Hedging Exposure

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

7
Current Issues

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

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